DESCRIPTION OF THE CHAIRMAN’S MODIFICATION

TO THE PROVISIONS OF THE

“JOBS AND GROWTH TAX ACT OF 2003”

Scheduled for Markup

By the

SENATE COMMITTEE ON FINANCE

on May 8, 2003

Prepared by the Staff

of the

JOINT COMMITTEE ON TAXATION

May 8, 2003

JCX-44-03
i

CONTENTS

Page

INTRODUCTION ..............................................................................................................................3

I. MODIFICATIONS TO THE JOBS AND GROWTH aCT OF 2003 ............................................4

A. Alternative Minimum Tax Exemption Amounts....................................................................4

B. Partial Exclusion of Dividend Income from Tax....................................................................5

II. NEW PROVISIONS......................................................................................................................7

A. Proposals Designed to Curtail Tax Shelters............................................................................7

1. Clarification of the economic substance doctrine...............................................................7

2. Penalty for failure to disclose reportable transactions......................................................13

3. Modifications to the accuracy-related penalties for listed transactions and reportable 

transactions having a significant tax avoidance purpose ......................................................16

4. Penalty for understatements from transactions lacking economic substance ...................20

5. Modifications to the substantial understatement penalty..................................................23

6. Tax shelter exception to confidentiality privileges relating to taxpayer 

communications....................................................................................................................24

7. Disclosure of reportable transactions by material advisors ..............................................25

8. Investor lists and modification of penalty for failure to maintain investor lists...............28

9. Actions to enjoin conduct with respect to tax shelters and reportable transactions..........30

10. Understatement of taxpayer’s liability by income tax return preparer...........................30

11. Penalty for failure to report interests in foreign financial accounts................................31

12. Frivolous tax returns and submissions............................................................................32

13. Penalties on promoters of tax shelters ............................................................................33

14. Extend statute of limitations for certain undisclosed transactions..................................34

15. Deny deduction for interest paid to IRS on underpayments involving certain taxmotivated transactions ..........................................................................................................34

B. Other Proposals.....................................................................................................................36

1. Affirmation of consolidated return regulation authority...................................................36

2. Chief Executive Officer Required To Sign Corporate Income Tax Returns....................41

C. Enron-Related Tax Shelter Related Provisions.....................................................................42

1. Limitation on transfer and importation of built-in losses .................................................42

2. No reduction of basis under section 734 in stock held by partnership in corporate 

partner...................................................................................................................................44

3. Repeal of special rules for FASITs...................................................................................46

4. Expanded disallowance of deduction for interest on convertible debt .............................50

5. Expanded authority to disallow tax benefits under section 269 .......................................52

6. Modification of CFC-PFIC coordination rules.................................................................53

D. Impose Mark-to-Market Tax on Individuals Who Expatriate ..............................................56

E. Extension of IRS User Fees..................................................................................................67

F. Provisions to Discourage Corporate Expatriation.................................................................68

1. Tax treatment of inversion transactions............................................................................68

2. Excise tax on stock compensation of insiders of inverted corporations...........................73

3. Reinsurance agreements....................................................................................................77
ii

G. Add Vaccines Against Hepatitis A to the List of Taxable Vaccines....................................79

H. Disallowance of Certain Partnership Loss Transfers............................................................80

I. Treatment of Stripped Bonds to Apply to Stripped Interests in Bond and Preferred 

Stock Funds...................................................................................................................................84

J. Reporting of Taxable Mergers and Acquisitions..................................................................88

K. Inclusion in Gross Income of Certain Deferred Compensation............................................90

L. Minimum Holding Period for Foreign Tax Credit with respect to Withholding Taxes 

on Income other than Dividends...................................................................................................94

M. Permit Private Sector Debt Collection Companies to Collect Tax Debts.............................96

N. Repeal the exclusion for foreign earned income and the exclusion or deduction for 

housing expenses ..........................................................................................................................98

O. Modify Qualification Rules for Tax-Exempt Property and Casualty 

Insurance Companies..................................................................................................................100

P. Authorize IRS to Enter into Installment Agreements that Provide for Partial Payment.....101

Q. Denial of Deduction for Certain Fines, Penalties, and Other Amounts..............................102

R. Deposits Made to Suspend the Running of Interest on Potential Underpayments.............104

S. Clarification of Rules For Payment of Estimated Tax for 

Certain Deemed Asset Sales.......................................................................................................107

T. Limit Deduction for Charitable Contributions of Patents and Similar Property ................109

U. Temporary State Fiscal Relief Fund ...................................................................................110

V. Extension of Customs User Fees........................................................................................111

W. SSI Redetermination ...........................................................................................................112

X. Covering Childless Adults with SCHIP Funds...................................................................113
3

INTRODUCTION

This document1, prepared by the staff of the Joint Committee on Taxation, provides a 

description of the Chairman’s modification to the provisions of the “Jobs and Growth Tax Act of 

2003.” The Senate Committee on Finance has scheduled a markup of this proposal for May 8, 

2003.

 

1

 This document may be cited as follows: Joint Committee on Taxation, Description of 

the Chairman’s Modification to the Provisions of the “Jobs and Growth Tax Act of 2003.” 

(JCX-44-03), May 8, 2003.
4

I. MODIFICATIONS TO 

THE JOBS AND GROWTH ACT OF 2003

The following modifications are made to the provisions of the Jobs and Growth Act of 

2003.

A. Alternative Minimum Tax Exemption Amounts

The proposal increases the AMT exemption amount for married taxpayers filing a joint 

return and surviving spouses to $61,000, and for unmarried taxpayers to $41,750, for taxable 

years beginning in 2003, 2004 and 2005.
5

B. Partial Exclusion of Dividend Income from Tax

Present Law

Under present law, dividends received by an individual are included in gross income and 

taxed as ordinary income at rates up to 38.6 percent.2

Description of Proposal

Under the proposal, an individual may exclude from gross income the first $500 ($250 in 

the case of a married individual filing a separate return) of dividends received from domestic 

corporations in a taxable year plus 10 percent (20 percent in the case of taxable years beginning 

after December 31, 2007) of the dividends received in excess of $500 (or $250). 

If a shareholder does not hold a share of stock for more than 45 days during the 90-day 

period beginning 45 days before the ex-dividend date (as measured under section 246(c)), 3

dividends received on the stock are not eligible for the exclusion. Also, the exclusion is not 

available for dividends to the extent that the taxpayer is obligated to make related payments with 

respect to positions in substantially similar or related property.

If an individual receives an extraordinary dividend (within the meaning of section 

1059(c)) eligible for the exclusion with respect to any share of stock, any loss on the sale of the 

stock is treated as a long-term capital loss to the extent of the amount of the dividend. 

A dividend is treated as investment income for purposes of determining the amount of 

deductible investment interest only if the taxpayer elects to treat the dividend as not eligible for 

the exclusion.

The amount of dividends qualifying for the exclusion that may be paid by a regulated 

investment company or real estate investment trust, for any taxable year that the aggregate 

qualifying dividends received by the company or trust are less than 95 percent of its gross 

income (as specially computed), may not exceed the amount of such aggregate dividends 

received by the company or trust.

The exclusion does not apply to dividends received from an organization that was exempt 

from tax under section 501 or was a tax-exempt farmers’ cooperative in either the taxable year of 

the distribution or the preceding taxable year; dividends received from a mutual savings bank 

that received a deduction under section 591; or deductible dividends paid on employer securities.

In the case of a nonresident alien, the exclusion applies only for purposes of determining 

the taxes imposed pursuant to sections 871(b) and 877.

 

2

 Another provision of the proposal reduces the maximum rate to 35 percent.

3

 In the case of preferred stock, the periods are doubled.
6

Dividends excluded under the proposal are included in modified adjusted gross income 

for purposes of the provisions of the Code determining the amount of any income inclusion, 

exclusion, deduction or credit based on the amount of that income. Also in determining 

eligibility for the earned income credit, any dividends excluded from gross income under this 

provision are included in disqualified income for purposes of the determining whether the 

individual has excessive investment income.

The tax rate for the accumulated earnings tax (sec. 531) and the personal holding 

company tax (sec. 541) is reduced to 90 percent (80 percent in the case of taxable years 

beginning after December 31, 2007) of the highest individual tax rate.

Amounts treated as ordinary income on the disposition of certain preferred stock (sec. 

306) are treated as dividends for purposes of the proposal.

The collapsible corporation rules (sec. 341) are repealed.

Effective Date

The proposal is effective for taxable years beginning after December 31, 2003, and 

beginning before January 1, 2013.
7

II. NEW PROVISIONS

A. Proposals Designed to Curtail Tax Shelters

1. Clarification of the economic substance doctrine 

Present Law

In general

The Code provides specific rules regarding the computation of taxable income, including 

the amount, timing, source, and character of items of income, gain, loss and deduction. These 

rules are designed to provide for the computation of taxable income in a manner that provides for 

a degree of specificity to both taxpayers and the government. Taxpayers generally may plan 

their transactions in reliance on these rules to determine the federal income tax consequences 

arising from the transactions. 

In addition to the statutory provisions, courts have developed several doctrines that can 

be applied to deny the tax benefits of tax motivated transactions, notwithstanding that the 

transaction may satisfy the literal requirements of a specific tax provision. The common-law 

doctrines are not entirely distinguishable, and their application to a given set of facts is often 

blurred by the courts and the IRS. Although these doctrines serve an important role in the 

administration of the tax system, invocation of these doctrines can be seen as at odds with an 

objective, “rule-based” system of taxation. Nonetheless, courts have applied the doctrines to 

deny tax benefits arising from certain transactions.4 

A common-law doctrine applied with increasing frequency is the “economic substance” 

doctrine. In general, this doctrine denies tax benefits arising from transactions that do not result 

in a meaningful change to the taxpayer’s economic position other than a purported reduction in 

federal income tax.5

Economic substance doctrine

Courts generally deny claimed tax benefits if the transaction that gives rise to those 

benefits lacks economic substance independent of tax considerations -- notwithstanding that the 

purported activity actually occurred. The tax court has described the doctrine as follows:

 

4

 See, e.g., ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998), aff’g 73 

T.C.M. (CCH) 2189 (1997), cert. denied 526 U.S. 1017 (1999).

5

 Closely related doctrines also applied by the courts (sometimes interchangeable with 

the economic substance doctrine) include the “sham transaction doctrine” and the “business 

purpose doctrine”. See, e.g., Knetsch v. United States, 364 U.S. 361 (1960) (denying interest 

deductions on a “sham transaction” whose only purpose was to create the deductions).
8

The tax law . . . requires that the intended transactions have economic substance 

separate and distinct from economic benefit achieved solely by tax reduction. 

The doctrine of economic substance becomes applicable, and a judicial remedy is 

warranted, where a taxpayer seeks to claim tax benefits, unintended by Congress, 

by means of transactions that serve no economic purpose other than tax savings.6

Business purpose doctrine

Another common law doctrine that overlays and is often considered together with (if not 

part and parcel of) the economic substance doctrine is the business purpose doctrine. The 

business purpose test is a subjective inquiry into the motives of the taxpayer -- that is, whether 

the taxpayer intended the transaction to serve some useful non-tax purpose. In making this 

determination, some courts have bifurcated a transaction in which independent activities with 

non-tax objectives have been combined with an unrelated item having only tax-avoidance 

objectives in order to disallow the tax benefits of the overall transaction.7

Application by the courts

Elements of the doctrine

There is a lack of uniformity regarding the proper application of the economic substance 

doctrine. Some courts apply a conjunctive test that requires a taxpayer to establish the presence 

of both economic substance (i.e., the objective component) and business purpose (i.e., the 

subjective component) in order for the transaction to sustain court scrutiny.8 A narrower 

approach used by some courts is to invoke the economic substance doctrine only after a 

determination that the transaction lacks both a business purpose and economic substance (i.e., the 

existence of either a business purpose or economic substance would be sufficient to respect the 

transaction).9 A third approach regards economic substance and business purpose as “simply 

 

6

 ACM Partnership v. Commissioner, 73 T.C.M. at 2215.

7

 ACM Partnership v. Commissioner, 157 F.3d at 256 n.48.

8

 See, e.g., Pasternak v. Commissioner, 990 F.2d 893, 898 (6th Cir. 1993) (“The 

threshold question is whether the transaction has economic substance. If the answer is yes, the 

question becomes whether the taxpayer was motivated by profit to participate in the 

transaction.”)

9

 See, e.g., Rice’s Toyota World v. Commissioner, 752 F.2d 89, 91-92 (4th Cir. 1985)

(“To treat a transaction as a sham, the court must find that the taxpayer was motivated by no 

business purposes other than obtaining tax benefits in entering the transaction, and, second, that 

the transaction has no economic substance because no reasonable possibility of a profit exists.”); 

IES Industries v. United States, 253 F.3d 350, 358 (8th Cir. 2001) (“In determining whether a 

transaction is a sham for tax purposes [under the Eighth Circuit test], a transaction will be 

characterized as a sham if it is not motivated by any economic purpose out of tax considerations 

(the business purpose test), and if it is without economic substance because no real potential for 

profit exists” (the economic substance test).”) As noted earlier, the economic substance doctrine 

and the sham transaction doctrine are similar and sometimes are applied interchangeably. For a 
9

more precise factors to consider” in determining whether a transaction has any practical 

economic effects other than the creation of tax benefits.10 

Profit potential

There also is a lack of uniformity regarding the necessity and level of profit potential 

necessary to establish economic substance. Since the time of Gregory, several courts have 

denied tax benefits on the grounds that the subject transactions lacked profit potential.11 In 

addition, some courts have applied the economic substance doctrine to disallow tax benefits in 

transactions in which a taxpayer was exposed to risk and the transaction had a profit potential, 

but the court concluded that the economic risks and profit potential were insignificant when 

compared to the tax benefits.12 Under this analysis, the taxpayer’s profit potential must be more 

than nominal. Conversely, other courts view the application of the economic substance doctrine 

as requiring an objective determination of whether a “reasonable possibility of profit” from the 

transaction existed apart from the tax benefits.13 In these cases, in assessing whether a 

 

more detailed discussion of the sham transaction doctrine, see, e.g., Joint Committee on 

Taxation, Study of Present-Law Penalty and Interest Provisions as Required by Section 3801 of 

the Internal Revenue Service Restructuring and Reform Act of 1998 (including Provisions 

Relating to Corporate Tax Shelters) (JCS-3-99) at 182.

10

 See, e.g., ACM Partnership v. Commissioner, 157 F.3d at 247; James v. 

Commissioner, 899 F.2d 905, 908 (10th Cir. 1995); Sacks v. Commissioner, 69 F.3d 982, 985 (9th

Cir. 1995) (“Instead, the consideration of business purpose and economic substance are simply 

more precise factors to consider . . ..We have repeatedly and carefully noted that this formulation 

cannot be used as a ‘rigid two-step analysis’.”).

11

 See, e.g., Knetsch, 364 U.S. at 361; Goldstein v. Commissioner, 364 F.2d 734 (2d Cir. 

1966) (holding that an unprofitable, leveraged acquisition of Treasury bills, and accompanying 

prepaid interest deduction, lacked economic substance); Ginsburg v. Commissioner, 35 T.C.M. 

(CCH) 860 (1976) (holding that a leveraged cattle-breeding program lacked economic 

substance).

12

 See, e.g., Goldstein v. Commissioner, 364 F.2d at 739-40 (disallowing deduction even 

though taxpayer had a possibility of small gain or loss by owning Treasury bills); Sheldon v. 

Commissioner, 94 T.C. 738, 768 (1990) (stating, “potential for gain . . . is infinitesimally 

nominal and vastly insignificant when considered in comparison with the claimed deductions”).

13

 See, e.g., Rice’s Toyota World v. Commissioner, 752 F.2d at 94 (the economic 

substance inquiry requires an objective determination of whether a reasonable possibility of 

profit from the transaction existed apart from tax benefits); Compaq Computer Corp. v. 

Commissioner, 277 F.3d at 781 (applied the same test, citing Rice’s Toyota World); IES 

Industries v. United States, 253 F.3d at 354 (the application of the objective economic substance 

test involves determining whether there was a “reasonable possibility of profit . . . apart from tax 

benefits.”). 
10

reasonable possibility of profit exists, it is sufficient if there is a nominal amount of pre-tax profit 

as measured against expected net tax benefits.

Description of Proposal

In general

The proposal clarifies and enhances the application of the economic substance doctrine. 

The proposal provides that a transaction has economic substance (and thus satisfies the economic 

substance doctrine) only if the taxpayer establishes that (1) the transaction changes in a 

meaningful way (apart from Federal income tax consequences) the taxpayer’s economic position, 

and (2) the taxpayer has a substantial non-tax purpose for entering into such transaction and the 

transaction is a reasonable means of accomplishing such purpose.14 

The proposal does not change current law standards used by courts in determining when 

to utilize an economic substance analysis. Also, the proposal does not alter the court's ability to 

aggregate or disaggregate a transaction when applying the doctrine. The proposal provides a 

uniform definition of economic substance, but does not alter court flexibility in other respects.

Conjunctive analysis

The proposal clarifies that the economic substance doctrine involves a conjunctive 

analysis -- there must be an objective inquiry regarding the effects of the transaction on the 

taxpayer’s economic position, as well as a subjective inquiry regarding the taxpayer’s motives

for engaging in the transaction. Under the proposal, a transaction must satisfy both tests -- i.e., it 

must change in a meaningful way (apart from Federal income tax consequences) the taxpayer’s 

economic position, and the taxpayer must have a substantial non-tax purpose for entering into 

such transaction (and the transaction is a reasonable means of accomplishing such purpose) -- in 

order to satisfy the economic substance doctrine. This clarification eliminates the disparity that 

exists among the circuits regarding the application of the doctrine, and modifies its application in 

those circuits in which either a change in economic position or a non-tax business purpose 

(without having both) is sufficient to satisfy the economic substance doctrine. 

Non-tax business purpose

The proposal provides that a taxpayer’s non-tax purpose for entering into a transaction 

(the second prong in the analysis) must be “substantial,” and that the transaction must be “a 

reasonable means” of accomplishing such purpose. Under this formulation, the non-tax purpose 

 

14 If the tax benefits are clearly contemplated and expected by the language and purpose 

of the relevant authority, it is not intended that such tax benefits be disallowed if the only reason 

for such disallowance is that the transaction fails the economic substance doctrine as defined in 

this proposal.
11

for the transaction must bear a reasonable relationship to the taxpayer’s normal business 

operations or investment activities.15 

In determining whether a taxpayer has a substantial non-tax business purpose, an 

objective of achieving a favorable accounting treatment for financial reporting purposes will not 

be treated as having a substantial non-tax purpose.16 Furthermore, a transaction that is expected 

to increase financial accounting income as a result of generating tax deductions or losses without 

a corresponding financial accounting charge (i.e., a permanent book-tax difference)17 should not 

be considered to have a substantial non-tax purpose unless a substantial non-tax purpose exists 

apart from the financial accounting benefits.18 

By requiring that a transaction be a “reasonable means” of accomplishing its non-tax 

purpose, the proposal broadens the ability of the courts to bifurcate a transaction in which 

independent activities with non-tax objectives are combined with an unrelated item having only 

tax-avoidance objectives in order to disallow the tax benefits of the overall transaction.

 

15

 See, Martin McMahon Jr., Economic Substance, Purposive Activity, and Corporate 

Tax Shelters, 94 Tax Notes 1017, 1023 (Feb. 25, 2002) (advocates “confining the most rigorous 

application of business purpose, economic substance, and purposive activity tests to transactions 

outside the ordinary course of the taxpayer’s business -- those transactions that do not appear to 

contribute to any business activity or objective that the taxpayer may have had apart from tax 

planning but are merely loss generators.”); Mark P. Gergen, The Common Knowledge of Tax 

Abuse, 54 SMU L. Rev. 131, 140 (Winter 2001) (“The message is that you can pick up tax gold 

if you find it in the street while going about your business, but you cannot go hunting for it.”).

16 However, if the tax benefits are clearly contemplated and expected by the language 

and purpose of the relevant authority, such tax benefits should not be disallowed solely because 

the transaction results in a favorable accounting treatment. An example is the repealed foreign 

sales corporation rules.

17 This includes tax deductions or losses that are anticipated to be recognized in a period 

subsequent to the period the financial accounting benefit is recognized. For example, FAS 109 

in some cases permits the recognition of financial accounting benefits prior to the period in 

which the tax benefits are recognized for income tax purposes.

18 Claiming that a financial accounting benefit constitutes a substantial non-tax purpose 

fails to consider the origin of the accounting benefit (i.e., reduction of taxes) and significantly 

diminishes the purpose for having a substantial non-tax purpose requirement. See, e.g., 

American Electric Power, Inc. v. U.S., 136 F. Supp. 2d 762, 791-92 (S.D. Ohio, 2001) (“AEP’s 

intended use of the cash flows generated by the [corporate-owned life insurance] plan is 

irrelevant to the subjective prong of the economic substance analysis. If a legitimate business 

purpose for the use of the tax savings ‘were sufficient to breathe substance into a transaction 

whose only purpose was to reduce taxes, [then] every sham tax-shelter device might succeed,’” 

citing Winn-Dixie v. Commissioner, 113 T.C. 254, 287 (1999)). 
12

Profit potential

Under the proposal, a taxpayer may rely on factors other than profit potential to 

demonstrate that a transaction results in a meaningful change in the taxpayer’s economic 

position; the proposal merely sets forth a minimum threshold of profit potential if that test is 

relied on to demonstrate a meaningful change in economic position. If a taxpayer relies on a 

profit potential, however, the present value of the reasonably expected pre-tax profit must be 

substantial in relation to the present value of the expected net tax benefits that would be allowed 

if the transaction were respected.19 Moreover, the profit potential must exceed a risk-free rate of 

return. In addition, in determining pre-tax profit, fees and other transaction expenses and foreign 

taxes are treated as expenses.

A lessor of tangible property subject to a qualified lease shall be considered to have 

satisfied the profit test with respect to the leased property. For this purpose, a ‘qualified lease” is 

a lease that satisfies the factors for advance ruling purposes as provided by the Treasury 

Department.20In applying the profit test to the lessor of tangible property, certain deductions and 

other applicable tax credits (such as the rehabilitation tax credit and the low income housing tax 

credit) are not taken into account in measuring tax benefits. Thus, a traditional leveraged lease is 

not affected by the proposal to the extent it meets the present law standards.

Transactions with tax-indifferent parties

The proposal also provides special rules for transactions with tax-indifferent parties. For 

this purpose, a tax-indifferent party means any person or entity not subject to Federal income tax, 

or any person to whom an item would have no substantial impact on its income tax liability. 

Under these rules, the form of a financing transaction will not be respected if the present value of 

the tax deductions to be claimed is substantially in excess of the present value of the anticipated 

economic returns to the lender. Also, the form of a transaction with a tax-indifferent party will 

not be respected if it results in an allocation of income or gain to the tax-indifferent party in 

excess of the tax-indifferent party’s economic gain or income or if the transaction results in the 

shifting of basis on account of overstating the income or gain of the tax-indifferent party.

Other rules

The Secretary may prescribe regulations which provide (1) exemptions from the 

application of this proposal, and (2) other rules as may be necessary or appropriate to carry out 

the purposes of the proposal. 

 

19 Thus, a “reasonable possibility of profit” will not be sufficient to establish that a 

transaction has economic substance.

20 See Rev. Proc. 2001-28, 2001-19 I.R.B. 1156 which provides guidelines that must be 

present for a lease to be eligible for advance ruling purposes. It is intended that a lease that 

satisfies Treasury Department guidelines for advance ruling purposes would be treated as a 

qualified lease.
13

No inference is intended as to the proper application of the economic substance doctrine 

under present law. In addition, except with respect to the economic substance doctrine, the 

proposal shall not be construed as altering or supplanting any other common law doctrine 

(including the sham transaction doctrine), and this proposal shall be construed as being additive 

to any such other doctrine.

Effective Date

The proposal applies to transactions entered into after the date of enactment.

2. Penalty for failure to disclose reportable transactions 

Present Law

Regulations under section 6011 require a taxpayer to disclose with its tax return certain 

information with respect to each “reportable transaction” in which the taxpayer participates.21 

There are six categories of reportable transactions. The first category is any transaction 

that is the same as (or substantially similar to)22 a transaction that is specified by the Treasury 

Department as a tax avoidance transaction whose tax benefits are subject to disallowance under 

present law (referred to as a “listed transaction”).23 

The second category is any transaction that is offered under conditions of confidentiality. 

In general, if a taxpayer’s disclosure of the structure or tax aspects of the transaction is limited in 

any way by an express or implied understanding or agreement with or for the benefit of any 

person who makes or provides a statement, oral or written, as to the potential tax consequences 

that may result from the transaction, it is considered offered under conditions of confidentiality 

(whether or not the understanding is legally binding).24 

 

21 On February 27, 2003, the Treasury Department and the IRS released final regulations 

regarding the disclosure of reportable transactions. In general, the regulations are effective for 

transactions entered into on or after February 28, 2003. 

The discussion of present law refers to the new regulations. The rules that apply with 

respect to transactions entered into on or before February 28, 2003, are contained in Treas. Reg. 

sec. 1.6011-4T in effect on the date the transaction was entered into.

22 The regulations clarify that the term “substantially similar” includes any transaction 

that is expected to obtain the same or similar types of tax consequences and that is either 

factually similar or based on the same or similar tax strategy. Further, the term must be broadly 

construed in favor of disclosure. Treas. Reg. sec. 1-6011-4(c)(4).

23 Treas. Reg. sec. 1.6011-4(b)(2).

24 Treas. Reg. sec. 1.6011-4(b)(3).
14

The third category of reportable transactions is any transaction for which (1) the taxpayer 

has the right to a full or partial refund of fees if the intended tax consequences from the 

transaction are not sustained or, (2) the fees are contingent on the intended tax consequences 

from the transaction being sustained.25

The fourth category of reportable transactions relates to any transaction resulting in a 

taxpayer claiming a loss (under section 165) of at least (1) $10 million in any single year or $20 

million in any combination of years by a corporate taxpayer or a partnership with only corporate 

partners; (2) $2 million in any single year or $4 million in any combination of years by all other 

partnerships, S corporations, trusts, and individuals; or (3) $50,000 in any single year for 

individuals or trusts if the loss arises with respect to foreign currency translation losses.26

The fifth category of reportable transactions refers to any transaction done by certain 

taxpayers27 in which the tax treatment of the transaction differs (or is expected to differ) by more 

than $10 million from its treatment for book purposes (using generally accepted accounting 

principles) in any year.28

The final category of reportable transactions is any transaction that results in a tax credit 

exceeding $250,000 (including a foreign tax credit) if the taxpayer holds the underlying asset for 

less than 45 days.29

Under present law, there is no specific penalty for failing to disclose a reportable 

transaction; however, such a failure may jeopardize a taxpayer’s ability to claim that any income 

tax understatement attributable to such undisclosed transaction is due to reasonable cause, and 

that the taxpayer acted in good faith.30 

 

25 Treas. Reg. sec. 1.6011-4(b)(4).

26 Treas. Reg. sec. 1.6011-4(b)(5). IRS Rev. Proc. 2003-24, 2003-11 I.R.B. 599, 

exempts certain types of losses from this reportable transaction category.

27 The significant book-tax category applies only to taxpayers that are reporting 

companies under the Securities Exchange Act of 1934 or business entities that have $250 million 

or more in gross assets.

28 Treas. Reg. sec. 1.6011-4(b)(6). IRS Rev. Proc. 2003-25, 2003-11 I.R.B. 601, 

exempts certain types of transactions from this reportable transaction category. 

29 Treas. Reg. sec. 1.6011-4(b)(7).

30 Section 6664(c) provides that a taxpayer can avoid the imposition of a section 6662 

accuracy-related penalty in cases where the taxpayer can demonstrate that there was reasonable 

cause for the underpayment and that the taxpayer acted in good faith. On December 31, 2002, 

the Treasury Department and IRS issued proposed regulations under sections 6662 and 6664 

(REG-126016-01) that limit the defenses available to the imposition of an accuracy-related 

penalty in connection with a reportable transaction when the transaction is not disclosed.
15

Description of Proposal

In general

The proposal creates a new penalty for any person who fails to include with any return or 

statement any required information with respect to a reportable transaction. The new penalty 

applies without regard to whether the transaction ultimately results in an understatement of tax, 

and applies in addition to any accuracy-related penalty that may be imposed.

Transactions to be disclosed

The proposal does not define the terms “listed transaction”31 or “reportable transaction,” 

nor does the proposal explain the type of information that must be disclosed in order to avoid the 

imposition of a penalty. Rather, the proposal authorizes the Treasury Department to define a 

“listed transaction” and a “reportable transaction” under section 6011. 

Penalty rate

The penalty for failing to disclose a reportable transaction is $50,000. The amount is 

increased to $100,000 if the failure is with respect to a listed transaction. For large entities and 

high net worth individuals, the penalty amount is doubled (i.e., $100,000 for a reportable 

transaction and $200,000 for a listed transaction). The penalty cannot be waived with respect to 

a listed transaction. As to reportable transactions, the penalty can be rescinded (or abated) only 

if: (1) the taxpayer on whom the penalty is imposed has a history of complying with the Federal 

tax laws, (2) it is shown that the violation is due to an unintentional mistake of fact, (3) imposing 

the penalty would be against equity and good conscience, and (4) rescinding the penalty would 

promote compliance with the tax laws and effective tax administration. The authority to rescind 

the penalty can only be exercised by the IRS Commissioner personally or the head of the Office 

of Tax Shelter Analysis. Thus, the penalty cannot be rescinded by a revenue agent, an Appeals 

officer, or any other IRS personnel. The decision to rescind a penalty must be accompanied by a 

record describing the facts and reasons for the action and the amount rescinded. There will be no 

taxpayer right to appeal a refusal to rescind a penalty. The IRS also is required to submit an 

annual report to Congress summarizing the application of the disclosure penalties and providing 

a description of each penalty rescinded under this proposal and the reasons for the rescission.

A “large entity” is defined as any entity with gross receipts in excess of $10 million in the 

year of the transaction or in the preceding year. A “high net worth individual” is defined as any 

individual whose net worth exceeds $2 million, based on the fair market value of the individual’s 

assets and liabilities immediately before entering into the transaction.

 

31 The proposal states that, except as provided in regulations, a listed transaction means a 

reportable transaction, which is the same as, or substantially similar to, a transaction specifically 

identified by the Secretary as a tax avoidance transaction for purposes of section 6011. For this 

purpose, it is expected that the definition of “substantially similar” will be the definition used in 

Treas. Reg. sec. 1.6011-4(c)(4). However, the Secretary may modify this definition (as well as 

the definitions of “listed transaction” and “reportable transactions”) as appropriate. 
16

A public entity that is required to pay a penalty for failing to disclose a listed transaction 

(or is subject to an understatement penalty attributable to a non-disclosed listed transaction, a 

non-disclosed reportable avoidance transaction,32 or a transaction that lacks economic substance) 

must disclose the imposition of the penalty in reports to the Securities and Exchange 

Commission for such period as the Secretary shall specify. The proposal applies without regard 

to whether the taxpayer determines the amount of the penalty to be material to the reports in 

which the penalty must appear, and treats any failure to disclose a transaction in such reports as a 

failure to disclose a listed transaction. A taxpayer must disclose a penalty in reports to the 

Securities and Exchange Commission once the taxpayer has exhausted its administrative and 

judicial remedies with respect to the penalty (or if earlier, when paid).

Effective Date

The proposal is effective for returns and statements the due date for which is after the 

date of enactment.

3. Modifications to the accuracy-related penalties for listed transactions and reportable 

transactions having a significant tax avoidance purpose 

Present Law

The accuracy-related penalty applies to the portion of any underpayment that is 

attributable to (1) negligence, (2) any substantial understatement of income tax, (3) any 

substantial valuation misstatement, (4) any substantial overstatement of pension liabilities, or (5) 

any substantial estate or gift tax valuation understatement. If the correct income tax liability 

exceeds that reported by the taxpayer by the greater of 10 percent of the correct tax or $5,000 

($10,000 in the case of corporations), then a substantial understatement exists and a penalty may 

be imposed equal to 20 percent of the underpayment of tax attributable to the understatement.33 

The amount of any understatement generally is reduced by any portion attributable to an item if 

(1) the treatment of the item is supported by substantial authority, or (2) facts relevant to the tax 

treatment of the item were adequately disclosed and there was a reasonable basis for its tax 

treatment.34 

Special rules apply with respect to tax shelters.35 For understatements by non-corporate 

taxpayers attributable to tax shelters, the penalty may be avoided only if the taxpayer establishes 

that, in addition to having substantial authority for the position, the taxpayer reasonably believed 

that the treatment claimed was more likely than not the proper treatment of the item. This 

reduction in the penalty is unavailable to corporate tax shelters. 

 

32 A reportable avoidance transaction is a reportable transaction with a significant tax 

avoidance purpose. 

33 Sec. 6662.

34 Sec. 6662(d)(2)(B).

35 Sec. 6662(d)(2)(C).
17

The understatement penalty generally is abated (even with respect to tax shelters) in cases 

in which the taxpayer can demonstrate that there was “reasonable cause” for the underpayment 

and that the taxpayer acted in good faith.36 The relevant regulations provide that reasonable 

cause exists where the taxpayer “reasonably relies in good faith on an opinion based on a 

professional tax advisor’s analysis of the pertinent facts and authorities [that] . . . unambiguously 

concludes that there is a greater than 50-percent likelihood that the tax treatment of the item will 

be upheld if challenged” by the IRS.37

Description of Proposal

In general

The proposal modifies the present-law accuracy related penalty by replacing the rules 

applicable to tax shelters with a new accuracy-related penalty that applies to listed transactions 

and reportable transactions with a significant tax avoidance purpose (hereinafter referred to as a 

“reportable avoidance transaction”).38 The penalty rate and defenses available to avoid the 

penalty vary depending on whether the transaction was adequately disclosed.

Disclosed transactions

In general, a 20-percent accuracy-related penalty is imposed on any understatement 

attributable to an adequately disclosed listed transaction or reportable avoidance transaction. 

The only exception to the penalty is if the taxpayer satisfies a more stringent reasonable cause 

and good faith exception (hereinafter referred to as the “strengthened reasonable cause 

exception”), which is described below. The strengthened reasonable cause exception is available 

only if the relevant facts affecting the tax treatment are adequately disclosed, there is or was 

substantial authority for the claimed tax treatment, and the taxpayer reasonably believed that the 

claimed tax treatment was more likely than not the proper treatment.

Undisclosed transactions

If the taxpayer does not adequately disclose the transaction, the strengthened reasonable 

cause exception is not available (i.e., a strict-liability penalty applies), and the taxpayer is subject 

to an increased penalty rate equal to 30 percent of the understatement. 

In addition, a public entity that is required to pay the 30 percent penalty must disclose the 

imposition of the penalty in reports to the SEC for such periods as the Secretary shall specify. 

The disclosure to the SEC applies without regard to whether the taxpayer determines the amount 

of the penalty to be material to the reports in which the penalty must appear, and any failure to 

disclose such penalty in the reports is treated as a failure to disclose a listed transaction. A 

 

36 Sec. 6664(c).

37 Treas. Reg. sec. 1.6662-4(g)(4)(i)(B); Treas. Reg. sec. 1.6664-4(c).

38 The terms “reportable transaction” and “listed transaction” have the same meanings as 

used for purposes of the penalty for failing to disclose reportable transactions.
18

taxpayer must disclose a penalty in reports to the SEC once the taxpayer has exhausted its 

administrative and judicial remedies with respect to the penalty (or if earlier, when paid).

Once the 30 percent penalty has been included in the Revenue Agent Report, the penalty 

cannot be compromised for purposes of a settlement without approval of the Commissioner 

personally or the head of the Office of Tax Shelter Analysis. Furthermore, the IRS is required to 

submit an annual report to Congress summarizing the application of this penalty and providing a 

description of each penalty compromised under this proposal and the reasons for the 

compromise. 

Determination of the understatement amount

The penalty is applied to the amount of any understatement attributable to the listed or 

reportable avoidance transaction without regard to other items on the tax return. For purposes of 

this proposal, the amount of the understatement is determined as the sum of (1) the product of the 

highest corporate or individual tax rate (as appropriate) and the increase in taxable income 

resulting from the difference between the taxpayer’s treatment of the item and the proper 

treatment of the item (without regard to other items on the tax return) 39, and (2) the amount of 

any decrease in the aggregate amount of credits which results from a difference between the 

taxpayer’s treatment of an item and the proper tax treatment of such item. 

Except as provided in regulations, a taxpayer’s treatment of an item shall not take into 

account any amendment or supplement to a return if the amendment or supplement is filed after 

the earlier of when the taxpayer is first contacted regarding an examination of the return or such 

other date as specified by the Secretary.

Strengthened reasonable cause exception

A penalty is not imposed under the proposal with respect to any portion of an 

understatement if it shown that there was reasonable cause for such portion and the taxpayer 

acted in good faith. Such a showing requires (1) adequate disclosure of the facts affecting the 

transaction in accordance with the regulations under section 6011,40 (2) that there is or was 

substantial authority for such treatment, and (3) that the taxpayer reasonably believed that such 

treatment was more likely than not the proper treatment. For this purpose, a taxpayer will be 

treated as having a reasonable belief with respect to the tax treatment of an item only if such 

belief (1) is based on the facts and law that exist at the time the tax return (that includes the item) 

is filed, and (2) relates solely to the taxpayer’s chances of success on the merits and does not take 

into account the possibility that (a) a return will not be audited, (b) the treatment will not be 

raised on audit, or (c) the treatment will be resolved through settlement if raised. 

 

39 For this purpose, any reduction in the excess of deductions allowed for the taxable 

year over gross income for such year, and any reduction in the amount of capital losses which 

would (without regard to section 1211) be allowed for such year, shall be treated as an increase 

in taxable income.

40

 See the previous discussion regarding the penalty for failing to disclose a reportable 

transaction.
19

A taxpayer may (but is not required to) rely on an opinion of a tax advisor in establishing 

its reasonable belief with respect to the tax treatment of the item. However, a taxpayer may not 

rely on an opinion of a tax advisor for this purpose if the opinion (1) is provided by a 

“disqualified tax advisor,” or (2) is a “disqualified opinion.”

Disqualified tax advisor

A disqualified tax advisor is any advisor who (1) is a material advisor41 and who 

participates in the organization, management, promotion or sale of the transaction or is related 

(within the meaning of section 267 or 707) to any person who so participates, (2) is compensated 

directly or indirectly42 by a material advisor with respect to the transaction, (3) has a fee 

arrangement with respect to the transaction that is contingent on all or part of the intended tax 

benefits from the transaction being sustained, or (4) as determined under regulations prescribed 

by the Secretary, has a continuing financial interest with respect to the transaction. 

A material advisor is considered as participating in the “organization” of a transaction if 

the advisor performs acts relating to the development of the transaction. This may include, for 

example, preparing documents (1) establishing a structure used in connection with the 

transaction (such as a partnership agreement), (2) describing the transaction (such as an offering 

memorandum or other statement describing the transaction), or (3) relating to the registration of 

the transaction with any federal, state or local government body.43 Participation in the 

“management” of a transaction means involvement in the decision-making process regarding any 

business activity with respect to the transaction. Participation in the “promotion or sale” of a 

transaction means involvement in the marketing or solicitation of the transaction to others. Thus, 

an advisor who provides information about the transaction to a potential participant is involved 

 

41 The term “material advisor” (defined below in connection with the new information 

filing requirements for material advisors) means any person who provides any material aid, 

assistance, or advice with respect to organizing, promoting, selling, implementing, or carrying 

out any reportable transaction, and who derives gross income in excess of $50,000 in the case of 

a reportable transaction substantially all of the tax benefits from which are provided to natural 

persons ($250,000 in any other case). 

42 This situation could arise, for example, when an advisor has an arrangement or 

understanding (oral or written) with an organizer, manager, or promoter of a reportable 

transaction that such party will recommend or refer potential participants to the advisor for an 

opinion regarding the tax treatment of the transaction. 

43 An advisor should not be treated as participating in the organization of a transaction if 

the advisor’s only involvement with respect to the organization of the transaction is the rendering 

of an opinion regarding the tax consequences of such transaction. However, such an advisor 

may be a “disqualified tax advisor” with respect to the transaction if the advisor participates in 

the management, promotion or sale of the transaction (or if the advisor is compensated by a 

material advisor, has a fee arrangement that is contingent on the tax benefits of the transaction, or 

as determined by the Secretary, has a continuing financial interest with respect to the 

transaction). 
20

in the promotion or sale of a transaction, as is any advisor who recommends the transaction to a 

potential participant. 

Disqualified opinion

An opinion may not be relied upon if the opinion (1) is based on unreasonable factual or 

legal assumptions (including assumptions as to future events), (2) unreasonably relies upon 

representations, statements, finding or agreements of the taxpayer or any other person, (3) does 

not identify and consider all relevant facts, or (4) fails to meet any other requirement prescribed 

by the Secretary.

Coordination with other penalties

Any understatement upon which a penalty is imposed under this proposal is not subject to 

the accuracy-related penalty under section 6662. However, such understatement is included for 

purposes of determining whether any understatement (as defined in sec. 6662(d)(2)) is a 

substantial understatement as defined under section 6662(d)(1).

The penalty imposed under this proposal shall not apply to any portion of an 

understatement to which a fraud penalty is applied under section 6663.

Effective Date

The proposal is effective for taxable years ending after the date of enactment.

4. Penalty for understatements from transactions lacking economic substance 

Present Law

An accuracy-related penalty applies to the portion of any underpayment that is 

attributable to (1) negligence, (2) any substantial understatement of income tax, (3) any 

substantial valuation misstatement, (4) any substantial overstatement of pension liabilities, or (5) 

any substantial estate or gift tax valuation understatement. If the correct income tax liability 

exceeds that reported by the taxpayer by the greater of 10 percent of the correct tax or $5,000 

($10,000 in the case of corporations), then a substantial understatement exists and a penalty may 

be imposed equal to 20 percent of the underpayment of tax attributable to the understatement.44 

The amount of any understatement is reduced by any portion attributable to an item if (1) the 

treatment of the item is supported by substantial authority, or (2) facts relevant to the tax 

treatment of the item were adequately disclosed and there was a reasonable basis for its tax 

treatment. 

Special rules apply with respect to tax shelters.45 For understatements by non-corporate 

taxpayers attributable to tax shelters, the penalty may be avoided only if the taxpayer establishes 

 

44 Sec. 6662.

45 Sec. 6662(d)(2)(C).
21

that, in addition to having substantial authority for the position, the taxpayer reasonably believed 

that the treatment claimed was more likely than not the proper treatment of the item. This 

reduction in the penalty is unavailable to corporate tax shelters. 

The penalty generally is abated (even with respect to tax shelters) in cases in which the 

taxpayer can demonstrate that there was “reasonable cause” for the underpayment and that the 

taxpayer acted in good faith.46 The relevant regulations provide that reasonable cause exists 

where the taxpayer “reasonably relies in good faith on an opinion based on a professional tax 

advisor’s analysis of the pertinent facts and authorities [that] . . . unambiguously concludes that 

there is a greater than 50-percent likelihood that the tax treatment of the item will be upheld if 

challenged” by the IRS.47

Description of Proposal

The proposal imposes a penalty for an understatement attributable to any transaction that 

lacks economic substance (referred to in the statute as a “non-economic substance transaction 

understatement”).48 The penalty rate is 40 percent (reduced to 20 percent if the taxpayer 

adequately discloses the relevant facts in accordance with regulations prescribed under section 

6011). No exceptions (including the reasonable cause or rescission rules) to the penalty would 

be available under the proposal (i.e., the penalty is a strict-liability penalty).

A “non-economic substance transaction” means any transaction if (1) the transaction 

lacks economic substance (as defined in the earlier proposal regarding the economic substance 

doctrine),49 (2) the transaction was not respected under the rules relating to transactions with taxindifferent parties (as described in the earlier proposal regarding the economic substance 

doctrine),50 or (3) any similar rule of law. For this purpose, a similar rule of law would include, 

for example, an understatement attributable to a transaction that is determined to be a sham 

transaction.

For purposes of this proposal, the calculation of an “understatement” is made in the same 

manner as in the separate proposal relating to accuracy-related penalties for listed and reportable 

 

46 Sec. 6664(c).

47 Treas. Reg. sec. 1.6662-4(g)(4)(i)(B); Treas. Reg. sec. 1.6664-4(c).

48 Thus, unlike the new accuracy-related penalty under section 6662A (which applies 

only to listed and reportable avoidance transactions), the new penalty under this proposal applies 

to any transaction that lacks economic substance.

49 The proposal provides that a transaction has economic substance only if: (1) the 

transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s 

economic position, and (2) the transaction has a substantial non-tax purpose for entering into 

such transaction and is a reasonable means of accomplishing such purpose.

50 The proposal provides that the form of a transaction that involves a tax-indifferent 

party will not be respected in certain circumstances.
22

avoidance transactions (new sec. 6662A). Thus, the amount of the understatement under this 

proposal would be determined as the sum of (1) the product of the highest corporate or individual 

tax rate (as appropriate) and the increase in taxable income resulting from the difference between 

the taxpayer’s treatment of the item and the proper treatment of the item (without regard to other 

items on the tax return), 51 and (2) the amount of any decrease in the aggregate amount of credits 

which results from a difference between the taxpayer’s treatment of an item and the proper tax 

treatment of such item. In essence, the penalty will apply to the amount of any understatement 

attributable solely to a non-economic substance transaction.

 Except as provided in regulations, the taxpayer’s treatment of an item will not take into 

account any amendment or supplement to a return if the amendment or supplement is filed after 

the earlier of the date the taxpayer is first contacted regarding an examination of the return or 

such other date as specified by the Secretary. 

A public entity that is required to pay a penalty under this proposal (regardless of whether 

the transaction was disclosed) must disclose the imposition of the penalty in reports to the SEC 

for such periods as the Secretary shall specify. The disclosure to the SEC applies without regard 

to whether the taxpayer determines the amount of the penalty to be material to the reports in 

which the penalty must appear, and any failure to disclose such penalty in the reports is treated as 

a failure to disclose a listed transaction. A taxpayer must disclose a penalty in reports to the SEC 

once the taxpayer has exhausted its administrative and judicial remedies with respect to the 

penalty (or if earlier, when paid). 

Once a penalty (regardless of whether the transaction was disclosed) has been included in 

the Revenue Agent Report, the penalty cannot be compromised for purposes of a settlement 

without approval of the Commissioner personally or the head of the Office of Tax Shelter 

Analysis. Furthermore, the IRS is required to submit an annual report to Congress summarizing 

the application of this penalty and providing a description of each penalty compromised under 

this proposal and the reasons for the compromise.

Any understatement to which a penalty is imposed under this proposal will not be subject 

to the accuracy-related penalty under section 6662 or under new 6662A (accuracy-related 

penalties for listed and reportable avoidance transactions). However, an understatement under 

this proposal would be taken into account for purposes of determining whether any 

understatement (as defined in sec. 6662(d)(2)) is a substantial understatement as defined under 

section 6662(d)(1). The penalty imposed under this proposal will not apply to any portion of an 

understatement to which a fraud penalty is applied under section 6663.

Effective Date

The proposal applies to transactions after the date of enactment.

 

51 For this purpose, any reduction in the excess of deductions allowed for the taxable 

year over gross income for such year, and any reduction in the amount of capital losses that 

would (without regard to section 1211) be allowed for such year, would be treated as an increase 

in taxable income.
23

5. Modifications to the substantial understatement penalty 

Present Law

Definition of substantial understatement

An accuracy-related penalty equal to 20 percent applies to any substantial understatement 

of tax. A “substantial understatement” exists if the correct income tax liability for a taxable year 

exceeds that reported by the taxpayer by the greater of 10 percent of the correct tax or $5,000 

($10,000 in the case of most corporations).52 

Reduction of understatement for certain positions

For purposes of determining whether a substantial understatement penalty applies, the 

amount of any understatement generally is reduced by any portion attributable to an item if (1) 

the treatment of the item is supported by substantial authority, or (2) facts relevant to the tax 

treatment of the item were adequately disclosed and there was a reasonable basis for its tax 

treatment.53

The Secretary is required to publish annually in the Federal Register a list of positions for 

which the Secretary believes there is not substantial authority and which affect a significant 

number of taxpayers.54

Description of Proposal

Definition of substantial understatement

The proposal modifies the definition of “substantial” for corporate taxpayers. Under the 

proposal, a corporate taxpayer has a substantial understatement if the amount of the 

understatement for the taxable year exceeds the lesser of (1) 10 percent of the tax required to be 

shown on the return for the taxable year (or, if greater, $10,000), or (2) $10 million.

Reduction of understatement for certain positions

The proposal elevates the standard that a taxpayer must satisfy in order to reduce the 

amount of an understatement for undisclosed items. With respect to the treatment of an item 

whose facts are not adequately disclosed, a resulting understatement is reduced only if the 

taxpayer had a reasonable belief that the tax treatment was more likely than not the proper 

treatment. The proposal also authorizes (but does not require) the Secretary to publish a list of 

positions for which it believes there is not substantial authority or there is no reasonable belief 

that the tax treatment is more likely than not the proper treatment (without regard to whether 

 

52 Sec. 6662(a) and (d)(1)(A).

53 Sec. 6662(d)(2)(B).

54 Sec. 6662(d)(2)(D).
24

such positions affect a significant number of taxpayers). The list shall be published in the 

Federal Register or the Internal Revenue Bulletin.

Effective Date

The proposal is effective for taxable years beginning after date of enactment.

6. Tax shelter exception to confidentiality privileges relating to taxpayer communications 

Present Law

In general, a common law privilege of confidentiality exists for communications between 

an attorney and client with respect to the legal advice the attorney gives the client. The Code 

provides that, with respect to tax advice, the same common law protections of confidentiality that 

apply to a communication between a taxpayer and an attorney also apply to a communication 

between a taxpayer and a federally authorized tax practitioner to the extent the communication 

would be considered a privileged communication if it were between a taxpayer and an attorney. 

This rule is inapplicable to communications regarding corporate tax shelters.

Description of Proposal

The proposal modifies the rule relating to corporate tax shelters by making it applicable 

to all tax shelters, whether entered into by corporations, individuals, partnerships, tax-exempt 

entities, or any other entity. Accordingly, communications with respect to tax shelters are not 

subject to the confidentiality proposal of the Code that otherwise applies to a communication 

between a taxpayer and a federally authorized tax practitioner.

Effective Date

The proposal is effective with respect to communications made on or after the date of 

enactment.
25

7. Disclosure of reportable transactions by material advisors 

Present Law

Registration of tax shelter arrangements

An organizer of a tax shelter is required to register the shelter with the Secretary not later 

than the day on which the shelter is first offered for sale.55 A “tax shelter” means any investment 

with respect to which the tax shelter ratio56 for any investor as of the close of any of the first five 

years ending after the investment is offered for sale may be greater than two to one and which is: 

(1) required to be registered under Federal or State securities laws, (2) sold pursuant to an 

exemption from registration requiring the filing of a notice with a Federal or State securities 

agency, or (3) a substantial investment (greater than $250,000 and at least five investors).57

Other promoted arrangements are treated as tax shelters for purposes of the registration 

requirement if: (1) a significant purpose of the arrangement is the avoidance or evasion of 

Federal income tax by a corporate participant; (2) the arrangement is offered under conditions of 

confidentiality; and (3) the promoter may receive fees in excess of $100,000 in the aggregate.58

In general, a transaction has a “significant purpose of avoiding or evading Federal income 

tax” if the transaction: (1) is the same as or substantially similar to a “listed transaction,”59 or (2) 

is structured to produce tax benefits that constitute an important part of the intended results of the 

arrangement and the promoter reasonably expects to present the arrangement to more than one 

taxpayer.60 Certain exceptions are provided with respect to the second category of transactions.61

An arrangement is offered under conditions of confidentiality if: (1) an offeree has an 

understanding or agreement to limit the disclosure of the transaction or any significant tax 

 

55 Sec. 6111(a).

56 The tax shelter ratio is, with respect to any year, the ratio that the aggregate amount of 

the deductions and 350 percent of the credits, which are represented to be potentially allowable 

to any investor, bears to the investment base (money plus basis of assets contributed) as of the 

close of the tax year.

57 Sec. 6111(c).

58 Sec. 6111(d).

59 Treas. Reg. sec. 301.6111-2(b)(2).

60 Treas. Reg. sec. 301.6111-2(b)(3).

61 Treas. Reg. sec. 301.6111-2(b)(4).
26

features of the transaction; or (2) the promoter knows, or has reason to know that the offeree’s 

use or disclosure of information relating to the transaction is limited in any other manner.62 

Failure to register tax shelter

The penalty for failing to timely register a tax shelter (or for filing false or incomplete 

information with respect to the tax shelter registration) generally is the greater of one percent of 

the aggregate amount invested in the shelter or $500.63 However, if the tax shelter involves an 

arrangement offered to a corporation under conditions of confidentiality, the penalty is the 

greater of $10,000 or 50 percent of the fees payable to any promoter with respect to offerings 

prior to the date of late registration. Intentional disregard of the requirement to register increases 

the penalty to 75 percent of the applicable fees.

Section 6707 also imposes (1) a $100 penalty on the promoter for each failure to furnish 

the investor with the required tax shelter identification number, and (2) a $250 penalty on the 

investor for each failure to include the tax shelter identification number on a return.

Description of Proposal

Disclosure of reportable transactions by material advisors

The proposal repeals the present law rules with respect to registration of tax shelters. 

Instead, the proposal requires each material advisor with respect to any reportable transaction 

(including any listed transaction)64 to timely file an information return with the Secretary (in 

such form and manner as the Secretary may prescribe). The return must be filed on such date as 

specified by the Secretary. 

The information return will include (1) information identifying and describing the 

transaction, (2) information describing any potential tax benefits expected to result from the 

transaction, and (3) such other information as the Secretary may prescribe. It is expected that the 

Secretary may seek from the material advisor the same type of information that the Secretary 

may request from a taxpayer in connection with a reportable transaction.65

 

62 The regulations provide that the determination of whether an arrangement is offered 

under conditions of confidentiality is based on all the facts and circumstances surrounding the 

offer. If an offeree’s disclosure of the structure or tax aspects of the transaction are limited in 

any way by an express or implied understanding or agreement with or for the benefit of a tax 

shelter promoter, an offer is considered made under conditions of confidentiality, whether or not 

such understanding or agreement is legally binding. Treas. Reg. sec. 301.6111-2(c)(1).

63 Sec. 6707.

64 The terms “reportable transaction” and “listed transaction” have the same meaning as 

previously described in connection with the taxpayer-related proposals.

65

 See the previous discussion regarding the disclosure requirements under new section 

6707A.
27

A “material advisor” means any person (1) who provides material aid, assistance, or 

advice with respect to organizing, promoting, selling, implementing, or carrying out any 

reportable transaction, and (2) who directly or indirectly derives gross income in excess of 

$250,000 ($50,000 in the case of a reportable transaction substantially all of the tax benefits from 

which are provided to natural persons) for such advice or assistance.

The Secretary may prescribe regulations which provide (1) that only one material advisor 

has to file an information return in cases in which two or more material advisors would otherwise 

be required to file information returns with respect to a particular reportable transaction, (2) 

exemptions from the requirements of this section, and (3) other rules as may be necessary or 

appropriate to carry out the purposes of this section (including, for example, rules regarding the 

aggregation of fees in appropriate circumstances).

Penalty for failing to furnish information regarding reportable transactions

The proposal repeals the present law penalty for failure to register tax shelters. Instead, 

the proposal imposes a penalty on any material advisor who fails to file an information return, or 

who files a false or incomplete information return, with respect to a reportable transaction 

(including a listed transaction).66 The amount of the penalty is $50,000. If the penalty is with 

respect to a listed transaction, the amount of the penalty is increased to the greater of (1) 

$200,000, or (2) 50 percent of the gross income of such person with respect to aid, assistance, or 

advice which is provided with respect to the transaction before the date the information return 

that includes the transaction is filed. Intentional disregard by a material advisor of the 

requirement to disclose a listed transaction increases the penalty to 75 percent of the gross 

income. 

The penalty cannot be waived with respect to a listed transaction. As to reportable 

transactions, the penalty can be rescinded (or abated) only in exceptional circumstances.67 All or 

part of the penalty may be rescinded only if: (1) the material advisor on whom the penalty is 

imposed has a history of complying with the Federal tax laws, (2) it is shown that the violation is 

due to an unintentional mistake of fact, (3) imposing the penalty would be against equity and 

good conscience, and (4) rescinding the penalty would promote compliance with the tax laws 

and effective tax administration. The authority to rescind the penalty can only be exercised by 

the Commissioner personally or the head of the Office of Tax Shelter Analysis; this authority to 

rescind cannot otherwise be delegated by the Commissioner. Thus, the penalty cannot be 

rescinded by a revenue agent, an Appeals officer, or other IRS personnel. The decision to 

rescind a penalty must be accompanied by a record describing the facts and reasons for the action 

and the amount rescinded. There will be no right to appeal a refusal to rescind a penalty. The 

IRS also is required to submit an annual report to Congress summarizing the application of the 

 

66 The terms “reportable transaction” and “listed transaction” have the same meaning as 

previously described in connection with the taxpayer-related proposals.

67 The Secretary’s present-law authority to postpone certain tax-related deadlines 

because of Presidentially-declared disasters (sec. 7508A) will also encompass the authority to 

postpone the reporting deadlines established by the proposal.
28

disclosure penalties and providing a description of each penalty rescinded under this proposal 

and the reasons for the rescission.

Effective Date

The proposal requiring disclosure of reportable transactions by material advisors applies 

to transactions with respect to which material aid, assistance or advice is provided after the date 

of enactment.

The proposal imposing a penalty for failing to disclose reportable transactions applies to 

returns the due date for which is after the date of enactment.

8. Investor lists and modification of penalty for failure to maintain investor lists 

Present Law

Investor lists

Any organizer or seller of a potentially abusive tax shelter must maintain a list identifying 

each person who was sold an interest in any such tax shelter with respect to which registration 

was required under section 6111 (even though the particular party may not have been subject to 

confidentiality restrictions).68 Recently issued regulations under section 6112 contain rules 

regarding the list maintenance requirements. 69 In general, the regulations apply to transactions 

that are potentially abusive tax shelters entered into, or acquired after, February 28, 2003.70

The regulations provide that a person is an organizer or seller of a potentially abusive tax 

shelter if the person is a material advisor with respect to that transaction.71 A material advisor is 

defined any person who is required to register the transaction under section 6111, or expects to 

receive a minimum fee of (1) $250,000 for a transaction that is a potentially abusive tax shelter if 

all participants are corporations, or (2) $50,000 for any other transaction that is a potentially 

abusive tax shelter.72 For listed transactions (as defined in the regulations under section 6011), 

the minimum fees are reduced to $25,000 and $10,000, respectively.

A potentially abusive tax shelter is any transaction that (1) is required to be registered

under section 6111, (2) is a listed transaction (as defined under the regulations under section 

 

68 Sec. 6112.

69 Treas. Reg. sec. 301-6112-1.

70 A special rule applies the list maintenance requirements to transactions entered into 

after February 28, 2000 if the transaction becomes a listed transaction (as defined in Treas. Reg. 

1.6011-4) after February 28, 2003.

71 Treas. Reg. sec. 301.6112-1(c)(1).

72 Treas. Reg. sec. 301.6112-1(c)(2) and (3).
29

6011), or (3) any transaction that a potential material advisor, at the time the transaction is 

entered into, knows is or reasonably expects will become a reportable transaction (as defined 

under the new regulations under section 6011).73 

The Secretary is required to prescribe regulations which provide that, in cases in which two or 

more persons are required to maintain the same list, only one person would be required to 

maintain the list.74

Penalty for failing to maintain investor lists

Under section 6708, the penalty for failing to maintain the list required under section 

6112 is $50 for each name omitted from the list (with a maximum penalty of $100,000 per year). 

Description of Proposal

Investor lists

Each material advisor75 with respect to a reportable transaction (including a listed 

transaction)76 is required to maintain a list that (1) identifies each person with respect to whom 

the advisor acted as a material advisor with respect to the reportable transaction, and (2) contains 

other information as may be required by the Secretary. In addition, the proposal authorizes (but 

does not require) the Secretary to prescribe regulations which provide that, in cases in which 2 or 

more persons are required to maintain the same list, only one person would be required to 

maintain the list.

Penalty for failing to maintain investor lists

The proposal modifies the penalty for failing to maintain the required list by making it a 

time-sensitive penalty. Thus, a material advisor who is required to maintain an investor list and 

who fails to make the list available upon written request by the Secretary within 20 business days 

after the request will be subject to a $10,000 per day penalty. The penalty applies to a person 

who fails to maintain a list, maintains an incomplete list, or has in fact maintained a list but does 

not make the list available to the Secretary. The penalty can be waived if the failure to make the 

list available is due to reasonable cause.77

 

73 Treas. Reg. sec. 301.6112-1(b).

74 Sec. 6112(c)(2).

75 The term “material advisor” has the same meaning as when used in connection with 

the requirement to file an information return under section 6111.

76 The terms “reportable transaction” and “listed transaction” have the same meaning as 

previously described in connection with the taxpayer-related proposals.

77 In no event will failure to maintain a list be considered reasonable cause for failing to 

make a list available to the Secretary.
30

Effective Date

The proposal requiring a material advisor to maintain an investor list applies to 

transactions with respect to which material aid, assistance or advice is provided after the date of 

enactment.

The proposal imposing a penalty for failing to maintain investor lists applies to requests 

made after the date of enactment. 

9. Actions to enjoin conduct with respect to tax shelters and reportable transactions 

Present Law

The Code authorizes civil action to enjoin any person from promoting abusive tax 

shelters or aiding or abetting the understatement of tax liability.78

Description of Proposal

The proposal expands this rule so that injunctions may also be sought with respect to the 

requirements relating to the reporting of reportable transactions79 and the keeping of lists of 

investors by material advisors.80 Thus, under the proposal, an injunction may be sought against a 

material advisor to enjoin the advisor from (1) failing to file an information return with respect to 

a reportable transaction, or (2) failing to maintain, or to timely furnish upon written request by 

the Secretary, a list of investors with respect to each reportable transaction.

Effective Date

The proposal is effective on the day after the date of enactment.

10. Understatement of taxpayer’s liability by income tax return preparer 

Present Law

An income tax return preparer who prepares a return with respect to which there is an 

understatement of tax that is due to a position for which there was not a realistic possibility of 

being sustained on its merits and the position was not disclosed (or was frivolous) is liable for a 

penalty of $250, provided that the preparer knew or reasonably should have known of the 

position. An income tax return preparer who prepares a return and engages in specified willful 

or reckless conduct with respect to preparing such a return is liable for a penalty of $1,000.

 

78 Sec. 7408.

79 Sec. 6707, as amended by other proposals of this bill.

80 Sec. 6708, as amended by other proposals of this bill.
31

Description of Proposal

The proposal alters the standards of conduct that must be met to avoid imposition of the 

first penalty. The proposal replaces the realistic possibility standard with a requirement that 

there be a reasonable belief that the tax treatment of the position was more likely than not the 

proper treatment. The proposal also replaces the not frivolous standard with the requirement that 

there be a reasonable basis for the tax treatment of the position. 

In addition, the proposal increases the amount of these penalties. The penalty relating to 

not having a reasonable belief that the tax treatment was more likely than not the proper tax 

treatment is increased from $250 to $1,000. The penalty relating to willful or reckless conduct is 

increased from $1,000 to $5,000.

Effective Date

The proposal is effective for documents prepared after the date of enactment.

11. Penalty for failure to report interests in foreign financial accounts 

Present Law

The Secretary of the Treasury must require citizens, residents, or persons doing business 

in the United States to keep records and file reports when that person makes a transaction or 

maintains an account with a foreign financial entity.81 In general, individuals must fulfill this 

requirement by answering questions regarding foreign accounts or foreign trusts that are 

contained in Part III of Schedule B of the IRS Form 1040. Taxpayers who answer “yes” in 

response to the question regarding foreign accounts must then file Treasury Department Form 

TD F 90-22.1. This form must be filed with the Department of the Treasury, and not as part of 

the tax return that is filed with the IRS.

The Secretary of the Treasury may impose a civil penalty on any person who willfully 

violates this reporting requirement. The civil penalty is the amount of the transaction or the 

value of the account, up to a maximum of $100,000; the minimum amount of the penalty is 

$25,000.82 In addition, any person who willfully violates this reporting requirement is subject to 

a criminal penalty. The criminal penalty is a fine of not more than $250,000 or imprisonment for 

not more than five years (or both); if the violation is part of a pattern of illegal activity, the 

maximum amount of the fine is increased to $500,000 and the maximum length of imprisonment 

is increased to 10 years.83

 

81 31 U.S.C. 5314.

82 31 U.S.C. 5321(a)(5).

83 31 U.S.C. 5322.
32

On April 26, 2002, the Secretary of the Treasury submitted to the Congress a report on 

these reporting requirements.84 This report, which was statutorily required,85 studies methods for 

improving compliance with these reporting requirements. It makes several administrative 

recommendations, but no legislative recommendations. A further report was required to be 

submitted by the Secretary of the Treasury to the Congress by October 26, 2002.

Description of Proposal

The proposal adds an additional civil penalty that may be imposed on any person who 

violates this reporting requirement (without regard to willfulness). This new civil penalty is up 

to $5,000. The penalty may be waived if any income from the account was properly reported on 

the income tax return and there was reasonable cause for the failure to report.

Effective Date

The proposal is effective with respect to failures to report occurring on or after the date of 

enactment.

12. Frivolous tax returns and submissions 

Present Law

The Code provides that an individual who files a frivolous income tax return is subject to 

a penalty of $500 imposed by the IRS (sec. 6702). The Code also permits the Tax Court86 to 

impose a penalty of up to $25,000 if a taxpayer has instituted or maintained proceedings 

primarily for delay or if the taxpayer’s position in the proceeding is frivolous or groundless (sec. 

6673(a)).

Description of Proposal

The proposal modifies the IRS-imposed penalty by increasing the amount of the penalty 

to up to $5,000 and by applying it to all taxpayers and to all types of Federal taxes.

The proposal also modifies present law with respect to certain submissions that raise 

frivolous arguments or that are intended to delay or impede tax administration. The submissions 

to which this proposal applies are requests for a collection due process hearing, installment 

agreements, offers-in-compromise, and taxpayer assistance orders. First, the proposal permits 

 

84

 A Report to Congress in Accordance with Sec. 361(b) of the Uniting and 

Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct 

Terrorism Act of 2001, April 26, 2002.

85 Sec. 361(b) of the USA PATRIOT Act of 2001 (Pub. L. 107-56).

86 Because in general the Tax Court is the only pre-payment forum available to 

taxpayers, it deals with most of the frivolous, groundless, or dilatory arguments raised in tax 

cases.
33

the IRS to dismiss such requests. Second, the proposal permits the IRS to impose a penalty of up 

to $5,000 for such requests, unless the taxpayer withdraws the request after being given an 

opportunity to do so.

The proposal requires the IRS to publish a list of positions, arguments, requests, and 

submissions determined to be frivolous for purposes of these proposals.

Effective Date

The proposal is effective for submissions made and issues raised after the date on which 

the Secretary first prescribes the required list.

13. Penalties on promoters of tax shelters 

Present Law

A penalty is imposed on any person who organizes, assists in the organization of, or 

participates in the sale of any interest in, a partnership or other entity, any investment plan or 

arrangement, or any other plan or arrangement, if in connection with such activity the person 

makes or furnishes a qualifying false or fraudulent statement or a gross valuation 

overstatement.87 A qualified false or fraudulent statement is any statement with respect to the 

allowability of any deduction or credit, the excludability of any income, or the securing of any 

other tax benefit by reason of holding an interest in the entity or participating in the plan or 

arrangement which the person knows or has reason to know is false or fraudulent as to any 

material matter. A “gross valuation overstatement” means any statement as to the value of any 

property or services if the stated value exceeds 200 percent of the correct valuation, and the 

value is directly related to the amount of any allowable income tax deduction or credit.

The amount of the penalty is $1,000 (or, if the person establishes that it is less, 100 

percent of the gross income derived or to be derived by the person from such activity). A 

penalty attributable to a gross valuation misstatement can be waived on a showing that there was 

a reasonable basis for the valuation and it was made in good faith.

Description of Proposal

The proposal modifies the penalty amount to equal 50 percent of the gross income 

derived by the person from the activity for which the penalty is imposed. The new penalty rate 

applies to any activity that involves a statement regarding the tax benefits of participating in a 

plan or arrangement if the person knows or has reason to know that such statement is false or 

fraudulent as to any material matter. The enhanced penalty does not apply to a gross valuation 

overstatement.

Effective Date

The proposal is effective for activities after the date of enactment.

 

87 Sec. 6700.
34

14. Extend statute of limitations for certain undisclosed transactions 

Present Law

In general, the Code requires that taxes be assessed within three years88 after the date a 

return is filed.89 If there has been a substantial omission of items of gross income that total more 

than 25 percent of the amount of gross income shown on the return, the period during which an 

assessment must be made is extended to six years.90 If an assessment is not made within the 

required time periods, the tax generally cannot be assessed or collected at any future time. Tax 

may be assessed at any time if the taxpayer files a false or fraudulent return with the intent to 

evade tax or if the taxpayer does not file a tax return at all.91

Description of Proposal

The proposal extends the statute of limitations to six years with respect to the entire tax 

return92 if a taxpayer required to disclose a listed transaction93 fails to do so in the manner 

required. For example, if a taxpayer entered into a transaction in 2005 that becomes a listed 

transaction in 2006 and the taxpayer fails to disclose such transaction in the manner required by 

Treasury regulations, the 2005 tax return will be subject to a six-year statute of limitations.94

Effective Date

The proposal is effective for transactions entered into in taxable years beginning after the 

date of enactment.

15. Deny deduction for interest paid to IRS on underpayments involving certain 

tax-motivated transactions 

 

88 Sec. 6501(a).

89 For this purpose, a return that is filed before the date on which it is due is considered 

to be filed on the required due date (sec. 6501(b)(1)).

90 Sec. 6501(e).

91 Sec. 6501(c).

92 The tax year extended is the tax year the transaction is entered into.

93 The term “listed transaction” has the same meaning as described in a previous 

proposal regarding the penalty for failure to disclose reportable transactions.

94 However, if the Treasury Department lists a transaction in a year subsequent to the 

year a taxpayer entered into such transaction, and the taxpayer’s tax return for the year the 

transaction was entered into is closed by the statute of limitations prior to the transaction 

becoming a listed transaction, this proposal does not re-open the statute of limitations for such 

year. 
35

Present Law

In general, corporations may deduct interest paid or accrued within a taxable year on 

indebtedness.95 Interest on indebtedness to the Federal government attributable to an 

underpayment of tax generally may be deducted pursuant to this provision. 

Description of Proposal

The proposal disallows any deduction for interest paid or accrued within a taxable year 

on any portion of an underpayment of tax that is attributable to an understatement arising from 

(1) an undisclosed reportable avoidance transaction, (2) an undisclosed listed transaction, or (3) a 

transaction that lacks economic substance.96

Effective Date

The proposal is effective for underpayments attributable to transactions entered into in 

taxable years beginning after the date of enactment. 

 

95 Sec. 163(a). 

96 The definitions of these transactions are the same as those previously described in 

connection with the proposal to modify the accuracy-related penalty for listed and certain 

reportable transactions and the proposal to impose a penalty on understatements attributable to 

transactions that lack economic substance.
36

B. Other Proposals

1. Affirmation of consolidated return regulation authority 

Present Law

An affiliated group of corporations may elect to file a consolidated return in lieu of 

separate returns. A condition of electing to file a consolidated return is that all corporations that 

are members of the consolidated group must consent to all the consolidated return regulations 

prescribed under section 1502 prior to the last day prescribed by law for filing such return.97 

Section 1502 states:

The Secretary shall prescribe such regulations as he may deem necessary in order that the 

tax liability of any affiliated group of corporations making a consolidated return and of 

each corporation in the group, both during and after the period of affiliation, may be 

returned, determined, computed, assessed, collected, and adjusted, in such manner as 

clearly to reflect the income-tax liability and the various factors necessary for the 

determination of such liability, and in order to prevent the avoidance of such tax 

liability.98

Under this authority, the Treasury Department has issued extensive consolidated return 

regulations.99

In the recent case of Rite Aid Corp. v. United States,100 the Federal Circuit Court of 

Appeals addressed the application of a particular provision of certain consolidated return loss 

 

97 Sec. 1501.

98 Sec. 1502. 

99 Regulations issued under the authority of section 1502 are considered to be 

“legislative” regulations rather than “interpretative” regulations, and as such are usually given 

greater deference by courts in case of a taxpayer challenge to such a regulation. See, S. Rep. No. 

960, 70th Cong., 1st Sess. at 15, describing the consolidated return regulations as “legislative in 

character”. The Supreme Court has stated that “. . . legislative regulations are given controlling 

weight unless they are arbitrary, capricious, or manifestly contrary to the statute.” Chevron, 

U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 844 (1984) (involving an 

environmental protection regulation). For examples involving consolidated return regulations, 

see, e.g., Wolter Construction Company v. Commissioner, 634 F.2d 1029 (6th Cir. 1980); 

Garvey, Inc. v.United States, 1 Ct. Cl. 108 (1983), aff’d 726 F.2d 1569 (Fed. Cir. 1984), cert. 

denied 469 U.S. 823 (1984). Compare, e.g., Audrey J. Walton v. Commissioner, 115 T.C. 589 

(2000), describing different standards of review. The case did not involve a consolidated return 

regulation. 

100 255 F.3d 1357 (Fed. Cir. 2001), reh’g denied, 2001 U.S. App. LEXIS 23207 (Fed. 

Cir. Oct. 3, 2001).
37

disallowance regulations, and concluded that the provision was invalid.101 The particular 

provision, known as the “duplicated loss” provision,102 would have denied a loss on the sale of 

stock of a subsidiary by a parent corporation that had filed a consolidated return with the 

subsidiary, to the extent the subsidiary corporation had assets that had a built-in loss, or had a net 

operating loss, that could be recognized or used later.103 

 

101 Prior to this decision, there had been a few instances involving prior laws in which 

certain consolidated return regulations were held to be invalid. See, e.g., American Standard, Inc. 

v. United States, 602 F.2d 256 (Ct. Cl. 1979), discussed in the text infra. see also Union Carbide 

Corp. v. United States, 612 F.2d 558 (Ct. Cl. 1979), and Allied Corporation v. United States, 685 

F. 2d 396 (Ct. Cl. 1982), all three cases involving the allocation of income and loss within a 

consolidated group for purposes of computation of a deduction allowed under prior law by the 

Code for Western Hemisphere Trading Corporations. See also Joseph Weidenhoff v. 

Commissioner, 32 T.C. 1222, 1242-1244 (1959), involving the application of certain regulations 

to the excess profits tax credit allowed under prior law, and concluding that the Commissioner 

had applied a particular regulation in an arbitrary manner inconsistent with the wording of the 

regulation and inconsistent with even a consolidated group computation. Cf. Kanawha Gas & 

Utilities Co. v. Commissioner, 214 F.2d 685 (1954), concluding that the substance of a 

transaction was an acquisition of assets rather than stock. Thus, a regulation governing basis of 

the assets of consolidated subsidiaries did not apply to the case. See also General Machinery 

Corporation v. Commissioner, 33 B.T.A. 1215 (1936); Lefcourt Realty Corporation, 31 B.T.A. 

978 (1935); Helvering v. Morgans, Inc., 293 U.S. 121 (1934), interpreting the term “taxable 

year.” 

102 Treas. Reg. Sec. 1.1502-20(c)(1)(iii).

103 Treasury Regulation section 1.1502-20, generally imposing certain “loss 

disallowance” rules on the disposition of subsidiary stock, contained other limitations besides the 

“duplicated loss” rule that could limit the loss available to the group on a disposition of a 

subsidiary’s stock. Treasury Regulation section 1.1502-20 as a whole was promulgated in 

connection with regulations issued under section 337(d), principally in connection with the socalled General Utilities repeal of 1986 (referring to the case of General Utilities & Operating 

Company v. Helvering, 296 U.S. 200 (1935)). Such repeal generally required a liquidating 

corporation, or a corporation acquired in a stock acquisition treated as a sale of assets, to pay 

corporate level tax on the excess of the value of its assets over the basis. Treasury regulation 

section 1.1502-20 principally reflected an attempt to prevent corporations filing consolidated 

returns from offsetting income with a loss on the sale of subsidiary stock. Such a loss could 

result from the unique upward adjustment of a subsidiary’s stock basis required under the 

consolidated return regulations for subsidiary income earned in consolidation, an adjustment 

intended to prevent taxation of both the subsidiary and the parent on the same income or gain. 

As one example, absent a denial of certain losses on a sale of subsidiary stock, a consolidated 

group could obtain a loss deduction with respect to subsidiary stock, the basis of which originally 

reflected the subsidiary’s value at the time of the purchase of the stock, and that had then been 

adjusted upward on recognition of any built-in income or gain of the subsidiary reflected in that 

value. The regulations also contained the duplicated loss factor addressed by the court in Rite 

Aid. The preamble to the regulations stated: “it is not administratively feasible to differentiate 
38

The Federal Circuit Court opinion contained language discussing the fact that the 

regulation produced a result different than the result that would have obtained if the corporations 

had filed separate returns rather than consolidated returns.104 

The Federal Circuit Court opinion cited a 1928 Senate Finance Committee Report to 

legislation that authorized consolidated return regulations, which stated that “many difficult and 

complicated problems, ... have arisen in the administration of the provisions permitting the filing 

of consolidated returns” and that the committee “found it necessary to delegate power to the 

commissioner to prescribe regulations legislative in character covering them.”105 The Court’s 

opinion also cited a previous decision of the Court of Claims for the proposition, interpreting this 

legislative history, that section 1502 grants the Secretary “the power to conform the applicable 

income tax law of the Code to the special, myriad problems resulting from the filing of 

consolidated income tax returns;” but that section 1502 “does not authorize the Secretary to 

choose a method that imposes a tax on income that would not otherwise be taxed.” 106

 

between loss attributable to built-in gain and duplicated loss.” T.D. 8364, 1991-2 C.B. 43, 46 

(Sept. 13, 1991). The government also argued in the Rite Aid case that duplicated loss was a 

separate concern of the regulations. 255 F.3d at 1360. 

104 For example, the court stated: “The duplicated loss factor . . . addresses a situation 

that arises from the sale of stock regardless of whether corporations file separate or consolidated 

returns. With I.R.C. secs. 382 and 383, Congress has addressed this situation by limiting the 

subsidiary’s potential future deduction, not the parent’s loss on the sale of stock under I.R.C. sec. 

165.” 255 F.3d 1357, 1360 (Fed. Cir. 2001).

105 S. Rep. No. 960, 70th Cong., 1st Sess. 15 (1928). Though not quoted by the court in 

Rite Aid, the same Senate report also indicated that one purpose of the consolidated return 

authority was to permit treatment of the separate corporations as if they were a single unit, 

stating “The mere fact that by legal fiction several corporations owned by the same shareholders 

are separate entities should not obscure the fact that they are in reality one and the same business 

owned by the same individuals and operated as a unit.” S. Rep. No. 960, 70th Cong., 1st Sess. 29 

(1928). 

106

 American Standard, Inc. v. United States, 602 F.2d 256, 261 (Ct. Cl. 1979). That 

case did not involve the question of separate returns as compared to a single return approach. It 

involved the computation of a Western Hemisphere Trade Corporation (“WHTC”) deduction 

under prior law (which deduction would have been computed as a percentage of each WHTC’s 

taxable income if the corporations had filed separate returns), in a case where a consolidated 

group included several WHTCs as well as other corporations. The question was how to 

apportion income and losses of the admittedly consolidated WHTCs and how to combine that 

computation with the rest of the group’s consolidated income or losses. The court noted that the 

new, changed regulations approach varied from the approach taken to a similar problem 

involving public utilities within a group and previously allowed for WHTCs. The court objected 

that the allocation method adopted by the regulation allowed non-WHTC losses to reduce 

WHTC income. However, the court did not disallow a method that would net WHTC income of 

one WHTC with losses of another WHTC, a result that would not have occurred under separate 
39

The Federal Circuit Court construed these authorities and applied them to invalidate 

Treas. Reg. Sec. 1.1502-20(c)(1)(iii), stating that:

The loss realized on the sale of a former subsidiary’s assets after the consolidated 

group sells the subsidiary’s stock is not a problem resulting from the filing of 

consolidated income tax returns. The scenario also arises where a corporate 

shareholder sells the stock of a non-consolidated subsidiary. The corporate 

shareholder could realize a loss under I.R.C. sec. 1001, and deduct the loss under 

I.R.C. sec. 165. The subsidiary could then deduct any losses from a later sale of 

assets. The duplicated loss factor, therefore, addresses a situation that arises from the 

sale of stock regardless of whether corporations file separate or consolidated returns. 

With I.R.C. secs. 382 and 383, Congress has addressed this situation by limiting the 

subsidiary’s potential future deduction, not the parent’s loss on the sale of stock under 

I.R.C. sec. 165.107

The Treasury Department has announced that it will not continue to litigate the validity of 

the duplicated loss provision of the regulations, and has issued interim regulations that permit 

taxpayers for all years to elect a different treatment, though they may apply the provision for the 

past if they wish.108

Description of Proposal

The proposal confirms that, in exercising its authority under section 1502 to issue 

consolidated return regulations, the Treasury Department may provide rules treating corporations 

filing consolidated returns differently from corporations filing separate returns. 

Thus, under the statutory authority of section 1502, the Treasury Department is 

authorized to issue consolidated return regulations utilizing either a single taxpayer or separate 

taxpayer approach or a combination of the two approaches, as Treasury deems necessary in order 

that the tax liability of any affiliated group of corporations making a consolidated return, and of 

each corporation in the group, both during and after the period of affiliation, may be determined 

and adjusted in such manner as clearly to reflect the income-tax liability and the various factors 

 

returns. Nor did the court expressly disallow a different fractional method that would net both 

income and losses of the WHTCs with those of other corporations in the consolidated group. 

The court also found that the regulation had been adopted without proper notice. 

107

 Rite Aid, 255 F.3d at 1360.

108

 See Temp. Reg. 1.1502-20T(i)(2). The Treasury Department has also indicated its 

intention to continue to study all the issues that the original loss disallowance regulations 

addressed (including issues of furthering single entity principles) and possibly issue different 

regulations (not including the particular approach of Treas. Reg. Sec. 1.1502-20(c)(1)(iii)) on the 

issues in the future. See Notice 2002-11, 2002-7 I.R.B. 526 (Feb. 19, 2002); T.D. 8984, 67 F.R. 

11034 (March 12, 2002); REG-102740-02, 67 F.R. 11070 (March 12, 2002); see also Notice 

2002-18, 2002-12 I.R.B. 644 (March 25, 2002). 
40

necessary for the determination of such liability, and in order to prevent avoidance of such 

liability. 

Rite Aid is thus overruled to the extent it suggests that there is not a problem that can be 

addressed in consolidated return regulations if application of a particular Code provision on a 

separate taxpayer basis would produce a result different from single taxpayer principles that may 

be used for consolidation. 

The proposal nevertheless allows the result of the Rite Aid case to stand with respect to 

the type of factual situation presented in the case. That is, the legislation provides for the 

override of the regulatory provision that took the approach of denying a loss on a 

deconsolidating disposition of stock of a consolidated subsidiary109 to the extent the subsidiary 

had net operating losses or built in losses that could be used later outside the group.110

 Retaining the result in the Rite Aid case with respect to the particular regulation section 

1.1502-20(c)(1)(iii) as applied to the factual situation of the case does not in any way prevent or 

invalidate the various approaches Treasury has announced it will apply or that it intends to 

consider in lieu of the approach of that regulation, including, for example, the denial of a loss on 

a stock sale if inside losses of a subsidiary may also be used by the consolidated group, and the 

possible requirement that inside attributes be adjusted when a subsidiary leaves a group.111

Effective Date

The proposal is effective for all years, whether beginning before, on, or after the date of 

enactment of the proposal.

No inference is intended that the results following from this proposal are not the same as 

the results under present law. 

 

109 Treas. Reg. Sec. 1.1502-20(c)(1)(iii).

110 The proposal is not intended to overrule the current Treasury Department regulations, 

which allow taxpayers for the past to follow Treasury Regulations Section 1.1502-20(c)(1)(iii), if 

they choose to do so. Temp. Reg. Sec. 1.1502-20T(i)(2). 

111

 See, e.g., Notice 2002-11, 2002-7 I.R.B. 526 (Feb. 19, 2002); T.D. 8984, 67 F.R. 

11034 (Mar.12, 2002); REG-102740-02, 67 F.R. 11070 (Mar.12, 2002); see also Notice 2002-

18, 2002-12 I.R.B. 644 (Mar. 25, 2002). In exercising its authority under section 1502, the 

Secretary is also authorized to prescribe rules that protect the purpose of General Utilities repeal 

using presumptions and other simplifying conventions.
41

2. Chief Executive Officer Required To Sign Corporate Income Tax Returns 

Present Law

The Code requires112 that the income tax return of a corporation must be signed by either 

the president, the vice-president, the treasurer, the assistant treasurer, the chief accounting 

officer, or any other officer of the corporation authorized by the corporation to sign the return.

The Code also imposes113 a criminal penalty on any person who willfully signs any tax 

return under penalties of perjury that that person does not believe to be true and correct with 

respect to every material matter at the time of filing. If convicted, the person is guilty of a 

felony; the Code imposes a fine of not more than $100,000114 ($500,000 in the case of a 

corporation) or imprisonment of not more than three years, or both, together with the costs of 

prosecution.

Description of Proposal

The proposal requires that the chief executive officer of a corporation sign that 

corporation’s income tax returns. If the corporation does not have a chief executive officer, the 

IRS may designate another officer of the corporation; otherwise, no other person is permitted to 

sign the income tax return of a corporation. It is intended that the IRS issue general guidance, 

such as a revenue procedure, to (1) address situations when a corporation does not have a chief 

executive officer, and (2) define who the chief executive officer is, in situations (for example) 

when the primary official bears a different title or when a corporation has multiple chief 

executive officers. It is intended that, in every instance, the highest ranking corporate officer 

(regardless of title) sign the tax return.

The proposal does not apply to the income tax returns of mutual funds;115 they are 

required to be signed as under present law.

Effective Date

The proposal is effective for returns filed after the date of enactment.

 

112 Sec. 6062.

113 Sec. 7206.

114 Pursuant to 18 U.S.C. 3571, the maximum fine for an individual convicted of a felony 

is $250,000.

115 The proposal does, however, apply to the income tax returns of mutual fund 

management companies and advisors.
42

C. Enron-Related Tax Shelter Related Provisions

1. Limitation on transfer and importation of built-in losses

Present Law

Generally, no gain or loss is recognized when one or more persons transfer property to a 

corporation in exchange for stock and immediately after the exchange such person or persons 

control the corporation.116 The transferor's basis in the stock of the controlled corporation is the 

same as the basis of the property contributed to the controlled corporation, increased by the 

amount of any gain (or dividend) recognized by the transferor on the exchange, and reduced by 

the amount of any money or property received, and by the amount of any loss recognized by the 

transferor.117

The basis of property received by a corporation, whether from domestic or foreign 

transferors, in a tax-free incorporation, reorganization, or liquidation of a subsidiary corporation 

is the same as the adjusted basis in the hands of the transferor, adjusted for gain or loss 

recognized by the transferor.118 

Description of Proposal

Importation of built-in losses

The proposal provides that if a net built-in loss is imported into the U.S in a tax-free 

organization or reorganization from persons not subject to U.S. tax, the basis of each property so 

transferred is its fair market value. A similar rule applies in the case of the tax-free liquidation 

by a domestic corporation of its foreign subsidiary. 

Under the proposal, a net built-in loss is treated as imported into the U.S. if the aggregate 

adjusted bases of property received by a transferee corporation exceeds the fair market value of 

the properties transferred. Thus, for example, if in a tax-free incorporation, some properties are 

received by a corporation from U. S. persons subject to tax, and some properties are received 

from foreign persons not subject to U.S. tax, this provision applies to limit the adjusted basis of 

each property received from the foreign persons to the fair market value of the property. In the 

case of a transfer by a partnership (either domestic or foreign), this provision applies as if the 

properties had been transferred by each of the partners in proportion to their interests in the 

partnership.

Limitation on transfer of built-in-losses in section 351 transactions

 

116 Sec. 351.

117 Sec. 358.

118 Secs. 334(b) and 362(a) and (b).
43

The proposal provides that if the aggregate adjusted bases of property contributed by a 

transferor (or by a control group of which the transferor is a member) to a corporation exceed the 

aggregate fair market value of the property transferred in a tax-free incorporation, the 

transferee’s aggregate basis of the properties is limited to the aggregate fair market value of the 

transferred property. Under the proposal, any required basis reduction is allocated among the 

transferred properties in proportion to after which the transferor owns at least 80 percent of the 

vote and value of the stock of the transferee corporation, any basis reduction required by the 

proposal is made to the stock received by the transferor and not to the assets transferred.

Effective Date

The proposal applies to transactions after February 13, 2003.
44

2. No reduction of basis under section 734 in stock held by 

partnership in corporate partner

Present Law

In general

Generally, a partner and the partnership do not recognize gain or loss on a contribution of 

property to a partnership.119 Similarly, a partner and the partnership generally do not recognize 

gain or loss on the distribution of partnership property.120 This includes current distributions and 

distributions in liquidation of a partner’s interest. 

Basis of property distributed in liquidation

The basis of property distributed in liquidation of a partner’s interest is equal to the 

partner’s tax basis in its partnership interest (reduced by any money distributed in the same 

transaction).121 Thus, the partnership’s tax basis in the distributed property is adjusted (increased 

or decreased) to reflect the partner’s tax basis in the partnership interest.

Election to adjust basis of partnership property 

When a partnership distributes partnership property, generally, the basis of partnership 

property is not adjusted to reflect the effects of the distribution or transfer. The partnership is 

permitted, however, to make an election (referred to as a 754 election) to adjust the basis of 

partnership property in the case of a distribution of partnership property.122 The effect of the 

754 election is that the partnership adjusts the basis of its remaining property to reflect any 

change in basis of the distributed property in the hands of the distributee partner resulting from 

the distribution transaction. Such a change could be a basis increase due to gain recognition, or a 

basis decrease due to the partner’s adjusted basis in its partnership interest exceeding the 

adjusted basis of the property received. If the 754 election is made, it applies to the taxable year 

with respect to which such election was filed and all subsequent taxable years. 

In the case of a distribution of partnership property to a partner with respect to which the 

754 election is in effect, the partnership increases the basis of partnership property by (1) any 

gain recognized by the distributee partner (2) the excess of the adjusted basis of the distributed 

property to the partnership immediately before its distribution over the basis of the property to 

the distributee partner, and decreases the basis of partnership property by (1) any loss recognized 

by the distributee partner and (2) the excess of the basis of the property to the distributee partner 

 

119 Sec. 721(a).

120 Sec. 731(a) and (b).

121 Sec. 732(b).

122 Sec. 754.
45

over the adjusted basis of the distributed property to the partnership immediately before the 

distribution.

The allocation of the increase or decrease in basis of partnership property is made in a 

manner which has the effect of reducing the difference between the fair market value and the 

adjusted basis of partnership properties.123 In addition, the allocation rules require that any 

increase or decrease in basis be allocated to partnership property of a like character to the 

property distributed. For this purpose, the two categories of assets are (1) capital assets and 

depreciable and real property used in the trade or business held for more than one year, and (2) 

any other property.124

Description of Proposal

The proposal provides that in applying the basis allocation rules to a distribution in 

liquidation of a partner’s interest, a partnership is precluded from decreasing the basis of 

corporate stock of a partner or a related person. Any decrease in basis that, absent the proposal, 

would have been allocated to the stock is allocated to other partnership assets. If the decrease in 

basis exceeds the basis of the other partnership assets, then gain is recognized by the partnership 

in the amount of the excess. 

Effective Date

The proposal applies to distributions after February 13, 2003.

 

123 Sec. 755(a).

124 Sec. 755(b).
46

3. Repeal of special rules for FASITs

Present Law

Financial asset securitization investment trusts

In 1996, Congress created a new type of statutory entity called a “financial asset 

securitization trust” (“FASIT”) that facilitates the securitization of debt obligations such as credit 

card receivables, home equity loans, and auto loans.125 A FASIT generally is not taxable; the 

FASIT’s taxable income or net loss flows through to the owner of the FASIT.

The ownership interest of a FASIT generally is required to be entirely held by a single 

domestic C corporation. In addition, a FASIT generally may hold only qualified debt 

obligations, and certain other specified assets, and is subject to certain restrictions on its 

activities. An entity that qualifies as a FASIT can issue one or more classes of instruments that 

meet certain specified requirements and treat those instruments as debt for Federal income tax 

purposes. Instruments issued by a FASIT bearing yields to maturity over five percentage points 

above the yield to maturity on specified United States government obligations (i.e., “high-yield 

interests”) must be held, directly or indirectly, only by domestic C corporations that are not 

exempt from income tax.

Qualification as a FASIT

To qualify as a FASIT, an entity must: (1) make an election to be treated as a FASIT for 

the year of the election and all subsequent years;126 (2) have assets substantially all of which 

(including assets that the FASIT is treated as owning because they support regular interests) are 

specified types called “permitted assets;” (3) have non-ownership interests be certain specified 

types of debt instruments called “regular interests”; (4) have a single ownership interest which is 

held by an "eligible holder"; and (5) not qualify as a regulated investment company (“RIC”). 

Any entity, including a corporation, partnership, or trust may be treated as a FASIT. In addition, 

a segregated pool of assets may qualify as a FASIT.

An entity ceases qualifying as a FASIT if the entity's owner ceases being an eligible 

corporation. Loss of FASIT status is treated as if all of the regular interests of the FASIT were 

retired and then reissued without the application of the rule that deems regular interests of a 

FASIT to be debt.

Permitted assets

 

125 Sections 860H through 860L.

126 Once an election to be a FASIT is made, the election applies from the date specified 

in the election and all subsequent years until the entity ceases to be a FASIT. If an election to be 

a FASIT is made after the initial year of an entity, all of the assets in the entity at the time of the 

FASIT election are deemed contributed to the FASIT at that time and, accordingly, any gain (but 

not loss) on such assets will be recognized at that time.
47

For an entity or arrangement to qualify as a FASIT, substantially all of its assets must 

consist of the following “permitted assets”: (1) cash and cash equivalents; (2) certain permitted 

debt instruments; (3) certain foreclosure property; (4) certain instruments or contracts that 

represent a hedge or guarantee of debt held or issued by the FASIT; (5) contract rights to acquire 

permitted debt instruments or hedges; and (6) a regular interest in another FASIT. Permitted 

assets may be acquired at any time by a FASIT, including any time after its formation.

“Regular interests” of a FASIT

“Regular interests” of a FASIT are treated as debt for Federal income tax purposes, 

regardless of whether instruments with similar terms issued by non-FASITs might be 

characterized as equity under general tax principles. To be treated as a “regular interest”, an 

instrument must have fixed terms and must: (1) unconditionally entitle the holder to receive a 

specified principal amount; (2) pay interest that is based on (a) fixed rates, or (b) except as 

provided by regulations issued by the Treasury Secretary, variable rates permitted with respect to 

REMIC interests under section 860G(a)(1)(B)(i); (3) have a term to maturity of no more than 30 

years, except as permitted by Treasury regulations; (4) be issued to the public with a premium of 

not more than 25 percent of its stated principal amount; and (5) have a yield to maturity 

determined on the date of issue of less than five percentage points above the applicable Federal 

rate (“AFR”) for the calendar month in which the instrument is issued.

Permitted ownership holder

A permitted holder of the ownership interest in a FASIT generally is a non-exempt (i.e., 

taxable) domestic C corporation, other than a corporation that qualifies as a RIC, REIT, REMIC, 

or cooperative.

Transfers to FASITs

In general, gain (but not loss) is recognized immediately by the owner of the FASIT upon 

the transfer of assets to a FASIT. Where property is acquired by a FASIT from someone other 

than the FASIT’s owner (or a person related to the FASIT’s owner), the property is treated as 

being first acquired by the FASIT’s owner for the FASIT’s cost in acquiring the asset from the 

non-owner and then transferred by the owner to the FASIT.

Valuation rules. In general, except in the case of debt instruments, the value of FASIT 

assets is their fair market value. Similarly, in the case of debt instruments that are traded on an 

established securities market, the market price is used for purposes of determining the amount of 

gain realized upon contribution of such assets to a FASIT. However, in the case of debt 

instruments that are not traded on an established securities market, special valuation rules apply 

for purposes of computing gain on the transfer of such debt instruments to a FASIT. Under these 

rules, the value of such debt instruments is the sum of the present values of the reasonably 

expected cash flows from such obligations discounted over the weighted average life of such 

assets. The discount rate is 120 percent of the AFR, compounded semiannually, or such other 

rate that the Treasury Secretary shall prescribe by regulations.
48

Taxation of a FASIT

A FASIT generally is not subject to tax. Instead, all of the FASIT’s assets and liabilities 

are treated as assets and liabilities of the FASIT’s owner and any income, gain, deduction or loss 

of the FASIT is allocable directly to its owner. Accordingly, income tax rules applicable to a 

FASIT (e.g., related party rules, sec. 871(h), sec. 165(g)(2)) are to be applied in the same manner 

as they apply to the FASIT’s owner. The taxable income of a FASIT is calculated using an 

accrual method of accounting. The constant yield method and principles that apply for purposes 

of determining original issue discount (“OID”) accrual on debt obligations whose principal is 

subject to acceleration apply to all debt obligations held by a FASIT to calculate the FASIT’s 

interest and discount income and premium deductions or adjustments.

Taxation of holders of FASIT regular interests

In general, a holder of a regular interest is taxed in the same manner as a holder of any 

other debt instrument, except that the regular interest holder is required to account for income 

relating to the interest on an accrual method of accounting, regardless of the method of 

accounting otherwise used by the holder.

Taxation of holders of FASIT ownership interests

Because all of the assets and liabilities of a FASIT are treated as assets and liabilities of 

the holder of a FASIT ownership interest, the ownership interest holder takes into account all of 

the FASIT’s income, gain, deduction, or loss in computing its taxable income or net loss for the 

taxable year. The character of the income to the holder of an ownership interest is the same as its 

character to the FASIT, except tax-exempt interest is included in the income of the holder as 

ordinary income.

Although the recognition of losses on assets contributed to the FASIT is not allowed 

upon contribution of the assets, such losses may be allowed to the FASIT owner upon their 

disposition by the FASIT. Furthermore, the holder of a FASIT ownership interest is not 

permitted to offset taxable income from the FASIT ownership interest (including gain or loss 

from the sale of the ownership interest in the FASIT) with other losses of the holder. In addition, 

any net operating loss carryover of the FASIT owner shall be computed by disregarding any 

income arising by reason of a disallowed loss. Where the holder of a FASIT ownership interest 

is a member of a consolidated group, this rule applies to the consolidated group of corporations 

of which the holder is a member as if the group were a single taxpayer.

Description of Proposal

The proposal repeals the special rules for FASITs. The proposal provides a transition 

period for existing FASITs, pursuant to which the repeal of the FASIT rules would not apply to 

any FASIT in existence on the date of enactment to the extent that regular interests issued by the 

FASIT prior to such date continue to remain outstanding in accordance with their original terms.
49

Effective Date

Except as provided by the transition period for existing FASITs, the proposal is effective 

after February 13, 2003.
50

4. Expanded disallowance of deduction for interest on convertible debt

Present Law

Whether an instrument qualifies for tax purposes as debt or equity is determined under all 

the facts and circumstances based on principles developed in case law. If an instrument qualifies 

as equity, the issuer generally does not receive a deduction for dividends paid and the holder 

generally includes such dividends in income (although corporate holders generally may obtain a 

dividends-received deduction of at least 70 percent of the amount of the dividend). If an 

instrument qualifies as debt, the issuer may receive a deduction for accrued interest and the 

holder generally includes interest in income, subject to certain limitations.

Original issue discount (“OID”) on a debt instrument is the excess of the stated 

redemption price at maturity over the issue price of the instrument. An issuer of a debt 

instrument with OID generally accrues and deducts the discount as interest over the life of the 

instrument even though interest may not be paid until the instrument matures. The holder of 

such a debt instrument also generally includes the OID in income on an accrual basis.

Under present law, no deduction is allowed for interest or OID on a debt instrument 

issued by a corporation (or issued by a partnership to the extent of its corporate partners) that is 

payable in equity of the issuer or a related party (within the meaning of sections 267(b) and 

707(b)), including a debt instrument a substantial portion of which is mandatorily convertible or 

convertible at the issuer's option into equity of the issuer or a related party.127 In addition, a debt 

instrument is treated as payable in equity if a substantial portion of the principal or interest is 

required to be determined, or may be determined at the option of the issuer or related party, by 

reference to the value of equity of the issuer or related party.128 A debt instrument also is treated 

as payable in equity if it is part of an arrangement that is designed to result in the payment of the 

debt instrument with or by reference to such equity, such as in the case of certain issuances of a 

forward contract in connection with the issuance of debt, nonrecourse debt that is secured 

principally by such equity, or certain debt instruments that are paid in, converted to, or 

determined with reference to the value of equity if it may be so required at the option of the 

holder or a related party and there is a substantial certainty that option will be exercised.129

Description of Proposal

The proposal expands the present-law disallowance of interest deductions on certain 

corporate debt that is payable in, or by reference to the value of, equity. Under the proposal, the 

disallowance includes interest on corporate debt that is payable in, or by reference to the value 

of, any equity held by the issuer (or any related party) in any other person, without regard to 

 

127 Sec. 163(l), enacted in the Taxpayer Relief Act of 1997, Pub. L. No. 105-34, sec. 

1005(a).

128 Sec. 163(l)(3)(B).

129 Sec. 163(l)(3)(C).
51

whether such equity represents more than a 50-percent ownership interest in such person. 

However, the proposal does not apply to debt that is issued by an active dealer in securities (or a 

related party) if the debt is payable in, or by reference to the value of, equity that is held by the 

securities dealer in its capacity as a dealer in securities.

Effective Date

This proposal applies to debt instruments that are issued after February 13, 2003.
52

5. Expanded authority to disallow tax benefits under section 269

Present Law

Section 269 provides that if a taxpayer acquires, directly or indirectly, control (defined as 

at least 50 percent of vote or value) of a corporation, and the principal purpose of the acquisition 

is the evasion or avoidance of Federal income tax by securing the benefit of a deduction, credit, 

or other allowance that would not otherwise have been available, the Secretary may disallow the 

such tax benefits.130 Similarly, if a corporation acquires, directly or indirectly, property of 

another corporation (not controlled, directly or indirectly, by the acquiring corporation or its 

stockholders immediately before the acquisition), the basis of such property is determined by 

reference to the basis in the hands of the transferor corporation, and the principal purpose of the 

acquisition is the evasion or avoidance of Federal income tax by securing a tax benefit that 

would not otherwise have been available, the Secretary may disallow such tax benefits.131 

Description of Proposal

The proposal expands section 269 by repealing (1) the requirement that the acquisition of 

stock be sufficient to obtain control of the corporation, and (2) the requirement that the 

acquisition of property be from a corporation not controlled by the acquirer. Thus, under the 

proposal, section 269 disallows the tax benefits of (1) any acquisition of stock in a 

corporation,132 and (2) any acquisition by a corporation of property from a corporation in which 

the basis of such property is determined by reference to the basis in the hands of the transferor 

corporation, if the principal purpose of such acquisition is the of evasion or avoidance of Federal 

income tax.

Effective Date

The proposal applies to stock and property acquired after February 13, 2003. 

 

130 Sec. 269(a)(1).

131 Sec. 269(a)(2).

132 In this regard, the proposal applies regardless of whether an acquisition results in an 

increase in the acquiror’s ownership percentage in a corporation or involves the issuance of

actual stock certificates or shares by a corporation to the acquiror.
53

6. Modification of CFC-PFIC coordination rules

Present Law

The United States employs a “worldwide” tax system, under which domestic corporations 

generally are taxed on all income, whether derived in the United States or abroad. Income 

earned by a domestic parent corporation from foreign operations conducted by foreign corporate 

subsidiaries generally is subject to U.S. tax when the income is distributed as a dividend to the 

domestic corporation. Until such repatriation, the U.S. tax on such income generally is deferred. 

However, certain anti-deferral regimes may cause the domestic parent corporation to be taxed on 

a current basis in the United States with respect to certain categories of passive or highly mobile 

income earned by its foreign subsidiaries, regardless of whether the income has been distributed 

as a dividend to the domestic parent corporation. The main anti-deferral regimes in this context 

are the controlled foreign corporation rules of subpart F133 and the passive foreign investment 

company rules.134 A foreign tax credit generally is available to offset, in whole or in part, the 

U.S. tax owed on foreign-source income, whether earned directly by the domestic corporation, 

repatriated as an actual dividend, or included under one of the anti-deferral regimes.135

Generally, income earned indirectly by a domestic corporation through a foreign 

corporation is subject to U.S. tax only when the income is distributed to the domestic 

corporation, because corporations generally are treated as separate taxable persons for Federal 

tax purposes. However, this deferral of U.S. tax is limited by anti-deferral regimes that impose 

current U.S. tax on certain types of income earned by certain corporations, in order to prevent 

taxpayers from avoiding U.S. tax by shifting passive or other highly mobile income into low-tax 

jurisdictions. Deferral of U.S. tax is considered appropriate, on the other hand, with respect to 

most types of active business income earned abroad.

Subpart F,136 applicable to controlled foreign corporations and their shareholders, is the 

main anti-deferral regime of relevance to a U.S.-based multinational corporate group. A 

controlled foreign corporation generally is defined as any foreign corporation if U.S. persons 

own (directly, indirectly, or constructively) more than 50 percent of the corporation’s stock 

(measured by vote or value), taking into account only those U.S. persons that own at least 10 

percent of the stock (measured by vote only).137 Under the subpart F rules, the United States 

generally taxes the U.S. 10-percent shareholders of a controlled foreign corporation on their pro 

 

133 Secs. 951-964.

134 Secs. 1291-1298.

135 Secs. 901, 902, 960, 1291(g).

136 Secs. 951-964.

137 Secs. 951(b), 957, 958.
54

rata shares of certain income of the controlled foreign corporation (referred to as “subpart F 

income”), without regard to whether the income is distributed to the shareholders.138 

Subpart F income generally includes passive income and other income that is readily 

movable from one taxing jurisdiction to another. Subpart F income consists of foreign base 

company income,139 insurance income,140 and certain income relating to international boycotts 

and other violations of public policy.141 Foreign base company income consists of foreign 

personal holding company income, which includes passive income (e.g., dividends, interest, 

rents, and royalties), as well as a number of categories of non-passive income, including foreign 

base company sales income, foreign base company services income, foreign base company 

shipping income and foreign base company oil-related income.142 

In effect, the United States treats the U.S. 10-percent shareholders of a controlled foreign 

corporation as having received a current distribution out of the corporation's subpart F income. 

In addition, the U.S. 10-percent shareholders of a controlled foreign corporation are required to 

include currently in income for U.S. tax purposes their pro rata shares of the corporation's 

earnings invested in U.S. property.143

The Tax Reform Act of 1986 established an additional anti-deferral regime, for passive 

foreign investment companies. A passive foreign investment company generally is defined as 

any foreign corporation if 75 percent or more of its gross income for the taxable year consists of 

passive income, or 50 percent or more of its assets consists of assets that produce, or are held for 

the production of, passive income.144 Alternative sets of income inclusion rules apply to U.S. 

persons that are shareholders in a passive foreign investment company, regardless of their 

percentage ownership in the company. One set of rules applies to passive foreign investment 

companies that are “qualified electing funds,” under which electing U.S. shareholders currently 

include in gross income their respective shares of the company’s earnings, with a separate 

election to defer payment of tax, subject to an interest charge, on income not currently 

received.145 A second set of rules applies to passive foreign investment companies that are not 

qualified electing funds, under which U.S. shareholders pay tax on certain income or gain 

realized through the company, plus an interest charge that is attributable to the value of 

 

138 Sec. 951(a).

139 Sec. 954.

140 Sec. 953.

141 Sec. 952(a)(3)-(5).

142 Sec. 954.

143 Secs. 951(a)(1)(B), 956.

144 Sec. 1297.

145 Sec. 1293-1295.
55

deferral.146 A third set of rules applies to passive foreign investment company stock that is 

marketable, under which electing U.S. shareholders currently take into account as income (or 

loss) the difference between the fair market value of the stock as of the close of the taxable year 

and their adjusted basis in such stock (subject to certain limitations), often referred to as 

“marking to market.”147

Under section 1297(e), which was enacted in 1997 to address the overlap of the passive 

foreign investment company rules and subpart F, a controlled foreign corporation generally is not 

also treated as a passive foreign investment company with respect to a U.S. shareholder of the 

corporation. This exception applies regardless of the likelihood that the U.S. shareholder would 

actually be taxed under subpart F in the event that the controlled foreign corporation earns 

subpart F income. Thus, even in a case in which a controlled foreign corporation’s subpart F 

income would be allocated to a different shareholder under the subpart F allocation rules, a U.S. 

shareholder would still qualify for the exception from the passive foreign investment company 

rules under section 1297(e).

Description of Proposal

The proposal adds an exception to section 1297(e) for U.S. shareholders that face only a 

remote likelihood of incurring a subpart F inclusion in the event that a controlled foreign 

corporation earns subpart F income, thus preserving the potential application of the passive 

foreign investment company rules in such cases.

Effective Date

The proposal is effective for taxable years of controlled foreign corporations beginning 

after February 13, 2003, and for taxable years of U.S. shareholders in which or with which such 

taxable years of controlled foreign corporations end.

 

146 Sec. 1291.

147 Sec. 1296.
56

D. Impose Mark-to-Market Tax on Individuals Who Expatriate

Present Law

In general

U.S. citizens and residents generally are subject to U.S. income taxation on their 

worldwide income. The U.S. tax may be reduced or offset by a credit allowed for foreign 

income taxes paid with respect to foreign-source income. Nonresidents who are not U.S. 

citizens are taxed at a flat rate of 30 percent (or a lower treaty rate) on certain types of 

passive income derived from U.S. sources, and at regular graduated rates on net profits 

derived from a U.S. business. 

Income tax rules with respect to expatriates

An individual who relinquishes his or her U.S. citizenship or terminates his or her 

U.S. residency with a principal purpose of avoiding U.S. taxes is subject to an alternative 

method of income taxation for the 10 taxable years ending after the expatriation or 

residency termination under section 877. The alternative method of taxation for 

expatriates modifies the rules generally applicable to the taxation of nonresident 

noncitizens in several ways. First, the individual is subject to tax on his or her U.S.-

source income at the rates applicable to U.S. citizens rather than the rates applicable to 

other nonresident noncitizens. Unlike U.S. citizens, however, individuals subject to 

section 877 are not taxed on foreign-source income. Second, the scope of items treated 

as U.S.-source income for section 877 purposes is broader than those items generally 

considered to be U.S.-source income under the Code.148 Third, individuals subject to 

section 877 are taxed on exchanges of certain types of property that give rise to U.S.-

source income for property that gives rise to foreign-source income.149 Fourth, an 

individual subject to section 877 who contributes property to a controlled foreign 

corporation is treated as receiving income or gain from such property directly and is 

taxable on such income or gain. The alternative method of taxation for expatriates 

 

148 For example, gains on the sale or exchange of personal property located in the 

United States, and gains on the sale or exchange of stocks and securities issued by U.S. 

persons, generally are not considered to be U.S.-source income under the Code. Thus, 

such gains would not be taxable to a nonresident noncitizen. However, if an individual is 

subject to the alternative regime under sec. 877, such gains are treated as U.S.-source 

income with respect to that individual.

149 For example, a former citizen who is subject to the alternative tax regime and 

who removes appreciated artwork that he or she owns from the United States could be 

subject to immediate U.S. tax on the appreciation. In this regard, the removal from the 

United States of appreciated tangible personal property having an aggregate fair market 

value in excess of $250,000 within the 15-year period beginning five years prior to the 

expatriation will be treated as an “exchange” subject to these rules.
57

applies only if it results in a higher U.S. tax liability than would otherwise be determined 

if the individual were taxed as a nonresident noncitizen.

The expatriation tax provisions apply to long-term residents of the United States 

whose U.S. residency is terminated. For this purpose, a long-term resident is any 

individual who was a lawful permanent resident of the United States for at least 8 out of 

the 15 taxable years ending with the year in which such termination occurs. In applying 

the 8-year test, an individual is not considered to be a lawful permanent resident for any 

year in which the individual is treated as a resident of another country under a treaty tiebreaker rule (and the individual does not elect to waive the benefits of such treaty). 

Subject to the exceptions described below, an individual is treated as having 

expatriated or terminated residency with a principal purpose of avoiding U.S. taxes if 

either: (1) the individual’s average annual U.S. Federal income tax liability for the 5 

taxable years ending before the date of the individual’s loss of U.S. citizenship or 

termination of U.S. residency is greater than $100,000 (the “tax liability test”), or (2) the 

individual’s net worth as of the date of such loss or termination is $500,000 or more (the 

“net worth test”). The dollar amount thresholds contained in the tax liability test and the 

net worth test are indexed for inflation in the case of a loss of citizenship or termination 

of residency occurring in any calendar year after 1996. An individual who falls below 

these thresholds is not automatically treated as having a principal purpose of tax 

avoidance, but nevertheless is subject to the expatriation tax provisions if the individual’s 

loss of citizenship or termination of residency in fact did have as one of its principal 

purposes the avoidance of tax.

Certain exceptions from the treatment that an individual relinquished his or her 

U.S. citizenship or terminated his or her U.S. residency for tax avoidance purposes may 

also apply. For example, a U.S. citizen who loses his or her citizenship and who satisfies 

either the tax liability test or the net worth test (described above) can avoid being deemed 

to have a principal purpose of tax avoidance if the individual falls within certain 

categories (such as being a dual citizen) and the individual, within one year from the date 

of loss of citizenship, submits a ruling request for a determination by the Secretary of the 

Treasury as to whether such loss had as one of its principal purposes the avoidance of 

taxes. 

Estate tax rules with respect to expatriates

Nonresident noncitizens generally are subject to estate tax on certain transfers of 

U.S.-situated property at death.150 Such property includes real estate and tangible 

property located within the United States. Moreover, for estate tax purposes, stock held 

by nonresident noncitizens is treated as U.S.-situated if issued by a U.S. corporation.

 

150 The Economic Growth and Tax Relief Reconciliation Act of 2001 (the “Act”) 

repealed the estate tax for estates of decedents dying after December 31, 2009. However, 

the Act included a “sunset” provision, pursuant to which the Act’s provisions (including 

estate tax repeal) do not apply to estates of decedents dying after December 31, 2010.
58

Special rules apply to U.S. citizens who relinquish their citizenship and long-term 

residents who terminate their U.S. residency within the 10 years prior to the date of death, 

unless the loss of status did not have as one its principal purposes the avoidance of tax 

(sec. 2107). Under these rules, the decedent’s estate includes the proportion of the 

decedent’s stock in a foreign corporation that the fair market value of the U.S.-situs assets 

owned by the corporation bears to the total assets of the corporation. This rule applies 

only if (1) the decedent owned, directly, at death 10 percent or more of the combined 

voting power of all voting stock of the corporation and (2) the decedent owned, directly 

or indirectly, at death more than 50 percent of the total voting stock of the corporation or 

more than 50 percent of the total value of all stock of the corporation. 

Taxpayers are deemed to have a principal purpose of tax avoidance if they meet 

the five-year tax liability test or the net worth test, discussed above. Exceptions from this 

tax avoidance treatment apply in the same circumstances as those described above 

(relating to certain dual citizens and other individuals who submit a timely and complete 

ruling request with the IRS as to whether their expatriation or residency termination had a 

principal purpose of tax avoidance).

Gift tax rules with respect to expatriates

Nonresident noncitizens generally are subject to gift tax on certain transfers by 

gift of U.S.-situated property. Such property includes real estate and tangible property 

located within the United States. Unlike the estate tax rules for U.S. stock held by 

nonresidents, however, nonresident noncitizens generally are not subject to U.S. gift tax 

on the transfer of intangibles, such as stock or securities, regardless of where such 

property is situated.

Special rules apply to U.S. citizens who relinquish their U.S. citizenship or longterm residents of the United States who terminate their U.S. residency within the 10 years 

prior to the date of transfer, unless such loss did not have as one of its principal purposes 

the avoidance of tax (sec. 2501(a)(3)). Under these rules, nonresident noncitizens are 

subject to gift tax on transfers of intangibles, such as stock or securities. Taxpayers are 

deemed to have a principal purpose of tax avoidance if they meet the five-year tax 

liability test or the net worth test, discussed above. Exceptions from this tax avoidance 

treatment apply in the same circumstances as those described above (relating to certain 

dual citizens and other individuals who submit a timely and complete ruling request with 

the IRS as to whether their expatriation or residency termination had a principal purpose 

of tax avoidance).

Other tax rules with respect to expatriates

The expatriation tax provisions permit a credit against the U.S. tax imposed under 

such provisions for any foreign income, gift, estate, or similar taxes paid with respect to 

the items subject to such taxation. This credit is available only against the tax imposed 

solely as a result of the expatriation tax provisions, and is not available to be used to 

offset any other U.S. tax liability.
59

In addition, certain information reporting requirements apply. Under these rules, 

a U.S. citizen who loses his or her citizenship is required to provide a statement to the 

State Department (or other designated government entity) that includes the individual's 

social security number, forwarding foreign address, new country of residence and 

citizenship, a balance sheet in the case of individuals with a net worth of at least 

$500,000, and such other information as the Secretary may prescribe. The information 

statement must be provided no later than the earliest day on which the individual (1) 

renounces the individual’s U.S. nationality before a diplomatic or consular officer of the 

United States, (2) furnishes to the U.S. Department of State a statement of voluntary 

relinquishment of U.S. nationality confirming an act of expatriation, (3) is issued a 

certificate of loss of U.S. nationality by the U.S. Department of State, or (4) loses U.S. 

nationality because the individual’s certificate of naturalization is canceled by a U.S. 

court. The entity to which such statement is to be provided is required to provide to the 

Secretary of the Treasury copies of all statements received and the names of individuals 

who refuse to provide such statements. A long-term resident whose U.S. residency is 

terminated is required to attach a similar statement to his or her U.S. income tax return 

for the year of such termination. An individual's failure to provide the required statement 

results in the imposition of a penalty for each year the failure continues equal to the 

greater of (1) 5 percent of the individual's expatriation tax liability for such year, or (2) 

$1,000.

The State Department is required to provide the Secretary of the Treasury with a 

copy of each certificate of loss of nationality approved by the State Department. 

Similarly, the agency administering the immigration laws is required to provide the 

Secretary of the Treasury with the name of each individual whose status as a lawful 

permanent resident has been revoked or has been determined to have been abandoned. 

Further, the Secretary of the Treasury is required to publish in the Federal Register the 

names of all former U.S. citizens with respect to whom it receives the required statements 

or whose names or certificates of loss of nationality it receives under the foregoing 

information-sharing provisions.

Immigration rules with respect to expatriates

Under U.S. immigration laws, any former U.S. citizen who officially renounces 

his or her U.S. citizenship and who is determined by the Attorney General to have 

renounced for the purpose of U.S. tax avoidance is ineligible to receive a U.S. visa and 

will be denied entry into the United States. This provision was included as an 

amendment (the “Reed amendment”) to immigration legislation that was enacted in 1996.

Description of Proposal

In general

The proposal generally subjects certain U.S. citizens who relinquish their U.S. 

citizenship and certain long-term U.S. residents who terminate their U.S. residence to tax 

on the net unrealized gain in their property as if such property were sold for fair market 

value on the day before the expatriation or residency termination. Gain from the deemed 
60

sale is taken into account at that time without regard to other Code provisions; any loss 

from the deemed sale generally would be taken into account to the extent otherwise 

provided in the Code. Any net gain on the deemed sale is recognized to the extent it 

exceeds $600,000 ($1.2 million in the case of married individuals filing a joint return, 

both of whom relinquish citizenship or terminate residency). The $600,000 amount is 

increased by a cost of living adjustment factor for calendar years after 2002.

Individuals covered

Under the proposal, the mark-to-market tax applies to U.S. citizens who 

relinquish citizenship and long-term residents who terminate U.S. residency. An 

individual is a long-term resident if he or she was a lawful permanent resident for at least 

eight out of the 15 taxable years ending with the year in which the termination of 

residency occurs. An individual is considered to terminate long-term residency when 

either the individual ceases to be a lawful permanent resident (i.e., loses his or her green 

card status), or the individual is treated as a resident of another country under a tax treaty 

and the individual does not waive the benefits of the treaty.

Exceptions from the mark-to-market tax are provided in two situations. The first 

exception applies to an individual who was born with citizenship both in the United 

States and in another country; provided that (1) as of the expatriation date the individual 

continues to be a citizen of, and is taxed as a resident of, such other country, and (2) the 

individual was not a resident of the United States for the five taxable years ending with 

the year of expatriation. The second exception applies to a U.S. citizen who relinquishes 

U.S. citizenship before reaching age 18 and a half, provided that the individual was a 

resident of the United States for no more than five taxable years before such 

relinquishment.

Election to be treated as a U.S. citizen

Under the proposal, an individual is permitted to make an irrevocable election to 

continue to be taxed as a U.S. citizen with respect to all property that otherwise is 

covered by the expatriation tax. This election is an “all or nothing” election; an 

individual is not permitted to elect this treatment for some property but not for other 

property. The election, if made, would apply to all property that would be subject to the 

expatriation tax and to any property the basis of which is determined by reference to such 

property. Under this election, the individual would continue to pay U.S. income taxes at 

the rates applicable to U.S. citizens following expatriation on any income generated by 

the property and on any gain realized on the disposition of the property. In addition, the 

property would continue to be subject to U.S. gift, estate, and generation-skipping 

transfer taxes. In order to make this election, the taxpayer would be required to waive 

any treaty rights that would preclude the collection of the tax. 

The individual also would be required to provide security to ensure payment of 

the tax under this election in such form, manner, and amount as the Secretary of the 

Treasury requires. The amount of mark-to-market tax that would have been owed but for 

this election (including any interest, penalties, and certain other items) shall be a lien in 
61

favor of the United States on all U.S.-situs property owned by the individual. This lien 

shall arise on the expatriation date and shall continue until the tax liability is satisfied, the 

tax liability has become unenforceable by reason of lapse of time, or the Secretary is 

satisfied that no further tax liability may arise by reason of this proposal. The rules of 

section 6324A(d)(1), (3), and (4) (relating to liens arising in connection with the deferral 

of estate tax under section 6166) apply to liens arising under this proposal. 

Date of relinquishment of citizenship

Under the proposal, an individual is treated as having relinquished U.S. 

citizenship on the earliest of four possible dates: (1) the date that the individual renounces 

U.S. nationality before a diplomatic or consular officer of the United States (provided 

that the voluntary relinquishment is later confirmed by the issuance of a certificate of loss 

of nationality); (2) the date that the individual furnishes to the State Department a signed 

statement of voluntary relinquishment of U.S. nationality confirming the performance of 

an expatriating act (again, provided that the voluntary relinquishment is later confirmed 

by the issuance of a certificate of loss of nationality); (3) the date that the State 

Department issues a certificate of loss of nationality; or (4) the date that a U.S. court 

cancels a naturalized citizen’s certificate of naturalization.

Deemed sale of property upon expatriation or residency termination

The deemed sale rule of the proposal generally applies to all property interests 

held by the individual on the date of relinquishment of citizenship or termination of 

residency. Special rules apply in the case of trust interests, as described below. U.S. real 

property interests, which remain subject to U.S. tax in the hands of nonresident 

noncitizens, generally are excepted from the proposal. Regulatory authority is granted to 

the Treasury to except other types of property from the proposal.

Under the proposal, an individual who is subject to the mark-to-market tax is 

required to pay a tentative tax equal to the amount of tax that would be due for a 

hypothetical short tax year ending on the date the individual relinquished citizenship or 

terminated residency. Thus, the tentative tax is based on all income, gain, deductions, 

loss, and credits of the individual for the year through such date, including amounts 

realized from the deemed sale of property. The tentative tax is due on the 90th day after 

the date of relinquishment of citizenship or termination of residency.

Retirement plans and similar arrangements

Subject to certain exceptions, the proposal applies to all property interests held by 

the individual at the time of relinquishment of citizenship or termination of residency. 

Accordingly, such property includes an interest in an employer-sponsored retirement plan 

or deferred compensation arrangement as well as an interest in an individual retirement 
62

account or annuity (i.e., an IRA).151 However, the proposal contains a special rule for an 

interest in a “qualified retirement plan.” For purposes of the proposal, a “qualified 

retirement plan” includes an employer-sponsored qualified plan (sec. 401(a)), a qualified 

annuity (sec. 403(a)), a tax-sheltered annuity (sec. 403(b)), an eligible deferred 

compensation plan of a governmental employer (sec. 457(b)), or an IRA (sec. 408). The 

special retirement plan rule applies also, to the extent provided in regulations, to any 

foreign plan or similar retirement arrangement or program. An interest in a trust that is 

part of a qualified retirement plan or other arrangement that is subject to the special 

retirement plan rule is not subject to the rules for interests in trusts (discussed below).

Under the special rule, an amount equal to the present value of the individual’s 

vested, accrued benefit under a qualified retirement plan is treated as having been 

received by the individual as a distribution under the plan on the day before the 

individual’s relinquishment of citizenship or termination of residency. It is not intended 

that the plan would be deemed to have made a distribution for purposes of the taxfavored status of the plan, such as whether a plan may permit distributions before a 

participant has severed employment. In the case of any later distribution to the individual 

from the plan, the amount otherwise includible in the individual’s income as a result of 

the distribution is reduced to reflect the amount previously included in income under the 

special retirement plan rule. The amount of the reduction applied to a distribution is the 

excess of: (1) the amount included in income under the special retirement plan rule over 

(2) the total reductions applied to any prior distributions. However, under the proposal, 

the retirement plan, and any person acting on the plan’s behalf, will treat any later 

distribution in the same manner as the distribution would be treated without regard to the 

special retirement plan rule.

It is expected that the Treasury Department will provide guidance for determining 

the present value of an individual’s vested, accrued benefit under a qualified retirement 

plan, such as the individual’s account balance in the case of a defined contribution plan or 

an IRA, or present value determined under the qualified joint and survivor annuity rules 

applicable to a defined benefit plan (sec. 417(e)).

Deferral of payment of tax

Under the proposal, an individual is permitted to elect to defer payment of the 

mark-to-market tax imposed on the deemed sale of the property. Interest is charged for 

the period the tax is deferred at a rate two percentage points higher than the rate normally 

applicable to individual underpayments. Under this election, the mark-to-market tax 

attributable to a particular property is due when the property is disposed of (or, if the 

property is disposed of in whole or in part in a nonrecognition transaction, at such other 

time as the Secretary may prescribe). The mark-to-market tax attributable to a particular 

property is an amount that bears the same ratio to the total mark-to-market tax for the 

 

151 Application of the provision is not limited to an interest that meets the 

definition of property under section 83 (relating to property transferred in connection 

with the performance of services).
63

year as the gain taken into account with respect to such property bears to the total gain 

taken into account under these rules for the year. The deferral of the mark-to-market tax 

may not be extended beyond the individual’s death.

In order to elect deferral of the mark-to-market tax, the individual is required to 

provide adequate security to the Treasury to ensure that the deferred tax and interest will 

be paid. Other security mechanisms are permitted provided that the individual

establishes to the satisfaction of the Secretary that the security is adequate. In the event 

that the security provided with respect to a particular property subsequently becomes 

inadequate and the individual fails to correct the situation, the deferred tax and the 

interest with respect to such property will become due. As a further condition to making 

the election, the individual is required to consent to the waiver of any treaty rights that 

would preclude the collection of the tax.

The deferred amount (including any interest, penalties, and certain other items) 

shall be a lien in favor of the United States on all U.S.-situs property owned by the 

individual. This lien shall arise on the expatriation date and shall continue until the tax 

liability is satisfied, the tax liability has become unenforceable by reason of lapse of time, 

or the Secretary is satisfied that no further tax liability may arise by reason of this 

proposal. The rules of section 6324A(d)(1), (3), and (4) (relating to liens arising in 

connection with the deferral of estate tax under section 6166) apply to liens arising under 

this proposal. 

Interests in trusts

Under the proposal, detailed rules apply to trust interests held by an individual at 

the time of relinquishment of citizenship or termination of residency. The treatment of 

trust interests depends on whether the trust is a qualified trust. A trust is a qualified trust 

if a court within the United States is able to exercise primary supervision over the 

administration of the trust and one or more U.S. persons have the authority to control all 

substantial decisions of the trust.

Constructive ownership rules apply to a trust beneficiary that is a corporation, 

partnership, trust, or estate. In such cases, the shareholders, partners, or beneficiaries of 

the entity are deemed to be the direct beneficiaries of the trust for purposes of applying 

these proposals. In addition, an individual who holds (or who is treated as holding) a 

trust instrument at the time of relinquishment of citizenship or termination of residency is 

required to disclose on his or her tax return the methodology used to determine his or her 

interest in the trust, and whether such individual knows (or has reason to know) that any 

other beneficiary of the trust uses a different method.

Nonqualified trusts.–If an individual holds an interest in a trust that is not a 

qualified trust, a special rule applies for purposes of determining the amount of the markto-market tax due with respect to such trust interest. The individual’s interest in the trust 

is treated as a separate trust consisting of the trust assets allocable to such interest. Such 

separate trust is treated as having sold its net assets as of the date of relinquishment of 

citizenship or termination of residency and having distributed the assets to the individual, 
64

who then is treated as having recontributed the assets to the trust. The individual is 

subject to the mark-to-market tax with respect to any net income or gain arising from the 

deemed distribution from the trust.

The election to defer payment is available for the mark-to-market tax attributable 

to a nonqualified trust interest. Interest is charged for the period the tax is deferred at a 

rate two percentage points higher than the rate normally applicable to individual 

underpayments. A beneficiary’s interest in a nonqualified trust is determined under all 

the facts and circumstances, including the trust instrument, letters of wishes, and 

historical patterns of trust distributions.

Qualified trusts.–If an individual has an interest in a qualified trust, the amount of 

unrealized gain allocable to the individual’s trust interest is calculated at the time of 

expatriation or residency termination. In determining this amount, all contingencies and 

discretionary interests are assumed to be resolved in the individual’s favor (i.e., the 

individual is allocated the maximum amount that he or she could receive). The mark-tomarket tax imposed on such gains is collected when the individual receives distributions 

from the trust, or if earlier, upon the individual’s death. Interest is charged for the period 

the tax is deferred at a rate two percentage points higher than the rate normally applicable 

to individual underpayments.

If an individual has an interest in a qualified trust, the individual is subject to the 

mark-to-market tax upon the receipt of distributions from the trust. These distributions 

also may be subject to other U.S. income taxes. If a distribution from a qualified trust is 

made after the individual relinquishes citizenship or terminates residency, the mark-tomarket tax is imposed in an amount equal to the amount of the distribution multiplied by 

the highest tax rate generally applicable to trusts and estates, but in no event will the tax 

imposed exceed the deferred tax amount with respect to the trust interest. For this 

purpose, the deferred tax amount is equal to (1) the tax calculated with respect to the 

unrealized gain allocable to the trust interest at the time of expatriation or residency 

termination, (2) increased by interest thereon, and (3) reduced by any mark-to-market tax 

imposed on prior trust distributions to the individual.

If any individual’s interest in a trust is vested as of the expatriation date (e.g., if 

the individual’s interest in the trust is non-contingent and non-discretionary), the gain 

allocable to the individual’s trust interest is determined based on the trust assets allocable 

to his or her trust interest. If the individual’s interest in the trust is not vested as of the 

expatriation date (e.g., if the individual’s trust interest is a contingent or discretionary 

interest), the gain allocable to his or her trust interest is determined based on all of the 

trust assets that could be allocable to his or her trust interest, determined by resolving all 

contingencies and discretionary powers in the individual’s favor. In the case where more 

than one trust beneficiary is subject to the expatriation tax with respect to trust interests 

that are not vested, the rules are intended to apply so that the same unrealized gain with 

respect to assets in the trust is not taxed to both individuals.

Mark-to-market taxes become due if the trust ceases to be a qualified trust, the 

individual disposes of his or her qualified trust interest, or the individual dies. In such 
65

cases, the amount of mark-to-market tax equals the lesser of (1) the tax calculated under 

the rules for nonqualified trust interests as of the date of the triggering event, or (2) the 

deferred tax amount with respect to the trust interest as of that date.

The tax that is imposed on distributions from a qualified trust generally is 

deducted and withheld by the trustees. If the individual does not agree to waive treaty 

rights that would preclude collection of the tax, the tax with respect to such distributions 

is imposed on the trust, the trustee is personally liable for the tax, and any other 

beneficiary has a right of contribution against such individual with respect to the tax. 

Similar rules apply when the qualified trust interest is disposed of, the trust ceases to be a 

qualified trust, or the individual dies.

Coordination with present-law alternative tax regime

The proposal provides a coordination rule with the present-law alternative tax 

regime. Under the proposal, the expatriation income tax rules under section 877, and the 

expatriation estate and gift tax rules under sections 2107 and 2501(a)(3) (described 

above), do not apply to a former citizen or former long-term resident whose expatriation 

or residency termination occurs on or after February 5, 2003.

Treatment of gifts and inheritances from a former citizen or former long-term 

resident

Under the proposal, the exclusion from income provided in section 102 (relating 

to exclusions from income for the value of property acquired by gift or inheritance) does 

not apply to the value of any property received by gift or inheritance from a former 

citizen or former long-term resident (i.e., an individual who relinquished U.S. citizenship 

or terminated U.S. residency), subject to the exceptions described above relating to 

certain dual citizens and minors. Accordingly, a U.S. taxpayer who receives a gift or 

inheritance from such an individual is required to include the value of such gift or 

inheritance in gross income and is subject to U.S. tax on such amount. Having included 

the value of the property in income, the recipient would then take a basis in the property 

equal to that value. The tax does not apply to property that is shown on a timely filed gift 

tax return and that is a taxable gift by the former citizen or former long-term resident, or 

property that is shown on a timely filed estate tax return and included in the gross U.S. 

estate of the former citizen or former long-term resident (regardless of whether the tax 

liability shown on such a return is reduced by credits, deductions, or exclusions available 

under the estate and gift tax rules). In addition, the tax does not apply to property in 

cases in which no estate or gift tax return is required to be filed, where no such return 

would have been required to be filed if the former citizen or former long-term resident 

had not relinquished citizenship or terminated residency, as the case may be. Applicable 

gifts or bequests that are made in trust are treated as made to the beneficiaries of the trust 

in proportion to their respective interests in the trust.
66

Information reporting

The proposal provides that certain information reporting requirements under 

present law (sec. 6039G) applicable to former citizens and former long-term residents 

also apply for purposes of the proposal.

Immigration rules

The proposal amends the immigration rules that deny tax-motivated expatriates 

reentry into the United States by removing the requirement that the expatriation be taxmotivated, and instead denies former citizens reentry into the United States if the 

individual is determined not to be in compliance with his or her tax obligations under the 

proposal’s expatriation tax proposals (regardless of the subjective motive for 

expatriating). For this purpose, the proposal permits the IRS to disclose certain items of 

return information of an individual, upon written request of the Attorney General or his 

delegate, as is necessary for making a determination under section 212(a)(10)(E) of the 

Immigration and Nationality Act. Specifically, the proposal would permit the IRS to 

disclose to the agency administering section 212(a)(10)(E) whether such taxpayer is in 

compliance with section 877A and identify the items of noncompliance. Recordkeeping 

requirements, safeguards, and civil and criminal penalties for unauthorized disclosure or 

inspection would apply to return information disclosed under this proposal.

Effective Date

The proposal generally is effective for U.S. citizens who relinquish citizenship or 

long-term residents who terminate their residency on or after February 5, 2003. The 

provisions relating to gifts and inheritances are effective for gifts and inheritances 

received from former citizens and former long-term residents on or after February 5, 

2003, whose expatriation or residency termination occurs on or after such date. The 

provisions relating to former citizens under U.S. immigration laws are effective on or 

after the date of enactment.
67

E. Extension of IRS User Fees

Present Law

The IRS provides written responses to questions of individuals, corporations, and 

organizations relating to their tax status or the effects of particular transactions for tax purposes. 

The IRS generally charges a fee for requests for a letter ruling, determination letter, opinion 

letter, or other similar ruling or determination. Public Law 104-117152 extended the statutory 

authorization for these user fees153 through September 30, 2003.

Description of Proposal

The proposal extends the statutory authorization for these user fees through September 

30, 2013. The proposal also moves the statutory authorization for these fees into the Code.154

Effective Date

The proposal, including moving the statutory authorization for these fees into the Code 

and repealing the off-Code statutory authorization for these fees, is effective for requests made 

after the date of enactment.

 

152 An Act to provide that members of the Armed Forces performing services for the 

peacekeeping efforts in Bosnia and Herzegovina, Croatia, and Macedonia shall be entitled to tax 

benefits in the same manner as if such services were performed in a combat zone, and for other 

purposes (March 20, 1996).

153 These user fees were originally enacted in section 10511 of the Revenue Act of 1987 

(Pub. Law No. 100-203, December 22, 1987).

154 The proposal also moves into the Code the user fee provision relating to pension plans 

that was enacted in section 620 of the Economic Growth and Tax Relief Reconciliation Act of 

2001 (Pub. L. 107-16, June 7, 2001).
68

F. Provisions to Discourage Corporate Expatriation

1. Tax treatment of inversion transactions

Present Law

Determination of corporate residence

The U.S. tax treatment of a multinational corporate group depends significantly on 

whether the top-tier “parent” corporation of the group is domestic or foreign. For purposes of 

U.S. tax law, a corporation is treated as domestic if it is incorporated under the law of the United 

States or of any State. All other corporations (i.e., those incorporated under the laws of foreign 

countries) are treated as foreign. Thus, place of incorporation determines whether a corporation 

is treated as domestic or foreign for purposes of U.S. tax law, irrespective of other factors that 

might be thought to bear on a corporation’s “nationality,” such as the location of the 

corporation’s management activities, employees, business assets, operations, or revenue sources, 

the exchanges on which the corporation’s stock is traded, or the residence of the corporation’s 

managers and shareholders.

U.S. taxation of domestic corporations

The United States employs a “worldwide” tax system, under which domestic corporations 

generally are taxed on all income, whether derived in the United States or abroad. In order to 

mitigate the double taxation that may arise from taxing the foreign-source income of a domestic 

corporation, a foreign tax credit for income taxes paid to foreign countries is provided to reduce 

or eliminate the U.S. tax owed on such income, subject to certain limitations. 

Income earned by a domestic parent corporation from foreign operations conducted by 

foreign corporate subsidiaries generally is subject to U.S. tax when the income is distributed as a 

dividend to the domestic corporation. Until such repatriation, the U.S. tax on such income is 

generally deferred. However, certain anti-deferral regimes may cause the domestic parent 

corporation to be taxed on a current basis in the United States with respect to certain categories 

of passive or highly mobile income earned by its foreign subsidiaries, regardless of whether the 

income has been distributed as a dividend to the domestic parent corporation. The main antideferral regimes in this context are the controlled foreign corporation rules of subpart F155 and 

the passive foreign investment company rules.156 A foreign tax credit is generally available to 

offset, in whole or in part, the U.S. tax owed on this foreign-source income, whether repatriated 

as an actual dividend or included under one of the anti-deferral regimes.

U.S. taxation of foreign corporations

The United States taxes foreign corporations only on income that has a sufficient nexus to 

the United States. Thus, a foreign corporation is generally subject to U.S. tax only on income 

 

155 Secs. 951-964.

156 Secs. 1291-1298.
69

that is “effectively connected” with the conduct of a trade or business in the United States. Such 

“effectively connected income” generally is taxed in the same manner and at the same rates as 

the income of a U.S. corporation. An applicable tax treaty may limit the imposition of U.S. tax 

on business operations of a foreign corporation to cases in which the business is conducted 

through a “permanent establishment” in the United States.

In addition, foreign corporations generally are subject to a gross-basis U.S. tax at a flat 

30-percent rate on the receipt of interest, dividends, rents, royalties, and certain similar types of 

income derived from U.S. sources, subject to certain exceptions. The tax generally is collected 

by means of withholding by the person making the payment. This tax may be reduced or 

eliminated under an applicable tax treaty. 

U.S. tax treatment of inversion transactions

Under present law, U.S. corporations may reincorporate in foreign jurisdictions and 

thereby replace the U.S. parent corporation of a multinational corporate group with a foreign 

parent corporation. These transactions are commonly referred to as “inversion” transactions. 

Inversion transactions may take many different forms, including stock inversions, asset 

inversions, and various combinations of and variations on the two. Most of the known 

transactions to date have been stock inversions. In one example of a stock inversion, a U.S. 

corporation forms a foreign corporation, which in turn forms a domestic merger subsidiary. The 

domestic merger subsidiary then merges into the U.S. corporation, with the U.S. corporation 

surviving, now as a subsidiary of the new foreign corporation. The U.S. corporation’s 

shareholders receive shares of the foreign corporation and are treated as having exchanged their 

U.S. corporation shares for the foreign corporation shares. An asset inversion reaches a similar 

result, but through a direct merger of the top-tier U.S. corporation into a new foreign corporation, 

among other possible forms. An inversion transaction may be accompanied or followed by 

further restructuring of the corporate group. For example, in the case of a stock inversion, in 

order to remove income from foreign operations from the U.S. taxing jurisdiction, the U.S. 

corporation may transfer some or all of its foreign subsidiaries directly to the new foreign parent 

corporation or other related foreign corporations. 

In addition to removing foreign operations from the U.S. taxing jurisdiction, the 

corporate group may derive further advantage from the inverted structure by reducing U.S. tax 

on U.S.-source income through various “earnings stripping” or other transactions. This may 

include earnings stripping through payment by a U.S. corporation of deductible amounts such as 

interest, royalties, rents, or management service fees to the new foreign parent or other foreign 

affiliates. In this respect, the post-inversion structure enables the group to employ the same taxreduction strategies that are available to other multinational corporate groups with foreign 

parents and U.S. subsidiaries, subject to the same limitations. These limitations under present 

law include section 163(j), which limits the deductibility of certain interest paid to related 

parties, if the payor’s debt-equity ratio exceeds 1.5 to 1 and the payor’s net interest expense 

exceeds 50 percent of its “adjusted taxable income.” More generally, section 482 and the 

regulations thereunder require that all transactions between related parties be conducted on terms 

consistent with an “arm’s length” standard, and permit the Secretary of the Treasury to reallocate 

income and deductions among such parties if that standard is not met.
70

Inversion transactions may give rise to immediate U.S. tax consequences at the 

shareholder and/or the corporate level, depending on the type of inversion. In stock inversions, 

the U.S. shareholders generally recognize gain (but not loss) under section 367(a), based on the 

difference between the fair market value of the foreign corporation shares received and the 

adjusted basis of the domestic corporation stock exchanged. To the extent that a corporation’s 

share value has declined, and/or it has many foreign or tax-exempt shareholders, the impact of 

this section 367(a) “toll charge” is reduced. The transfer of foreign subsidiaries or other assets to 

the foreign parent corporation also may give rise to U.S. tax consequences at the corporate level 

(e.g., gain recognition and earnings and profits inclusions under sections 1001, 311(b), 304, 367, 

1248 or other provisions). The tax on any income recognized as a result of these restructurings 

may be reduced or eliminated through the use of net operating losses, foreign tax credits, and 

other tax attributes. 

In asset inversions, the U.S. corporation generally recognizes gain (but not loss) under 

section 367(a) as though it had sold all of its assets, but the shareholders generally do not 

recognize gain or loss, assuming the transaction meets the requirements of a reorganization under 

section 368.

Description of Proposal

In general

The proposal defines two different types of corporate inversion transactions and 

establishes a different set of consequences for each type. Certain partnership transactions also 

are covered. 

Transactions involving at least 80 percent identity of stock ownership

The first type of inversion is a transaction in which, pursuant to a plan or a series of 

related transactions: (1) a U.S. corporation becomes a subsidiary of a foreign-incorporated entity 

or otherwise transfers substantially all of its properties to such an entity;157 (2) the former 

shareholders of the U.S. corporation hold (by reason of holding stock in the U.S. corporation) 80 

percent or more (by vote or value) of the stock of the foreign-incorporated entity after the 

transaction; and (3) the foreign-incorporated entity, considered together with all companies 

connected to it by a chain of greater than 50 percent ownership (i.e., the “expanded affiliated 

group”), does not have substantial business activities in the entity’s country of incorporation, 

compared to the total worldwide business activities of the expanded affiliated group. The 

provision denies the intended tax benefits of this type of inversion by deeming the top-tier 

foreign corporation to be a domestic corporation for all purposes of the Code.158 

 

157 It is expected that the Treasury Secretary will issue regulations applying the term 

“substantially all” in this context and will not be bound in this regard by interpretations of the 

term in other contexts under the Code.

158 Since the top-tier foreign corporation is treated for all purposes of the Code as 

domestic, the shareholder-level “toll charge” of sec. 367(a) does not apply to these inversion 

transactions. However, with respect to inversion transactions completed before 2004, regulated 
71

Except as otherwise provided in regulations, the provision does not apply to a direct or 

indirect acquisition of the properties of a U.S. corporation no class of the stock of which was 

traded on an established securities market at any time within the four-year period preceding the 

acquisition. In determining whether a transaction would meet the definition of an inversion 

under the provision, stock held by members of the expanded affiliated group that includes the 

foreign incorporated entity is disregarded. For example, if the former top-tier U.S. corporation 

receives stock of the foreign incorporated entity (e.g., so-called “hook” stock), the stock would 

not be considered in determining whether the transaction meets the definition. Stock sold in a 

public offering (whether initial or secondary) or private placement related to the transaction also 

is disregarded for these purposes. Acquisitions with respect to a domestic corporation or 

partnership are deemed to be “pursuant to a plan” if they occur within the four-year period 

beginning on the date which is two years before the ownership threshold under the provision is 

met with respect to such corporation or partnership.

Transfers of properties or liabilities as part of a plan a principal purpose of which is to 

avoid the purposes of the provision are disregarded. In addition, the Treasury Secretary is 

granted authority to prevent the avoidance of the purposes of the provision, including avoidance 

through the use of related persons, pass-through or other noncorporate entities, or other 

intermediaries, and through transactions designed to qualify or disqualify a person as a related 

person, a member of an expanded affiliated group, or a publicly traded corporation. Similarly, 

the Treasury Secretary is granted authority to treat certain non-stock instruments as stock, and 

certain stock as not stock, where necessary to carry out the purposes of the provision. 

Transactions involving greater than 50 percent but less than 80 percent identity of stock 

ownership

The second type of inversion is a transaction that would meet the definition of an 

inversion transaction described above, except that the 80-percent ownership threshold is not met. 

In such a case, if a greater-than-50-percent ownership threshold is met, then a second set of rules 

applies to the inversion. Under these rules, the inversion transaction is respected (i.e., the foreign 

corporation is treated as foreign), but: (1) any applicable corporate-level “toll charges” for 

establishing the inverted structure may not be offset by tax attributes such as net operating losses 

or foreign tax credits; (2) the IRS is given expanded authority to monitor related-party 

transactions that may be used to reduce U.S. tax on U.S.-source income going forward; and (3) 

section 163(j), relating to “earnings stripping” through related-party debt, is strengthened. These 

measures generally apply for a 10-year period following the inversion transaction. In addition, 

inverting entities are required to provide information to shareholders or partners and the IRS with 

respect to the inversion transaction.

With respect to “toll charges,” any applicable corporate-level income or gain required to 

be recognized under sections 304, 311(b), 367, 1001, 1248, or any other provision with respect to 

the transfer of controlled foreign corporation stock or other assets by a U.S. corporation as part 

of the inversion transaction or after such transaction to a related foreign person is taxable, 

 

investment companies and certain similar entities are allowed to elect to recognize gain as if sec. 

367(a) did apply.
72

without offset by any tax attributes (e.g., net operating losses or foreign tax credits). To the 

extent provided in regulations, this rule will not apply to certain transfers of inventory and 

similar transactions conducted in the ordinary course of the taxpayer’s business.

In order to enhance IRS monitoring of related-party transactions, the provision 

establishes a new pre-filing procedure. Under this procedure, the taxpayer will be required 

annually to submit an application to the IRS for an agreement that all return positions to be taken 

by the taxpayer with respect to related-party transactions comply with all relevant provisions of 

the Code, including sections 163(j), 267(a)(3), 482, and 845. The Treasury Secretary is given the 

authority to specify the form, content, and supporting information required for this application, 

as well as the timing for its submission.

The IRS will be required to take one of the following three actions within 90 days of 

receiving a complete application from a taxpayer: (1) conclude an agreement with the taxpayer 

that the return positions to be taken with respect to related-party transactions comply with all 

relevant provisions of the Code; (2) advise the taxpayer that the IRS is satisfied that the 

application was made in good faith and substantially complies with the requirements set forth by 

the Treasury Secretary for such an application, but that the IRS reserves substantive judgment as 

to the tax treatment of the relevant transactions pending the normal audit process; or (3) advise 

the taxpayer that the IRS has concluded that the application was not made in good faith or does 

not substantially comply with the requirements set forth by the Treasury Secretary.

In the case of a compliance failure described in (3) above (and in cases in which the 

taxpayer fails to submit an application), the following sanctions will apply for the taxable year 

for which the application was required: (1) no deductions or additions to basis or cost of goods 

sold for payments to foreign related parties will be permitted; (2) any transfers or licenses of 

intangible property to related foreign parties will be disregarded; and (3) any cost-sharing 

arrangements will not be respected. In such a case, the taxpayer may seek direct review by the 

U.S. Tax Court of the IRS’s determination of compliance failure.

If the IRS fails to act on the taxpayer’s application within 90 days of receipt, then the 

taxpayer will be treated as having submitted in good faith an application that substantially

complies with the above-referenced requirements. Thus, the deduction disallowance and other 

sanctions described above will not apply, but the IRS will be able to examine the transactions at 

issue under the normal audit process. The IRS is authorized to request that the taxpayer extend 

this 90-day deadline in cases in which the IRS believes that such an extension might help the 

parties to reach an agreement. 

The “earnings stripping” rules of section 163(j), which deny or defer deductions for 

certain interest paid to foreign related parties, are strengthened for inverted corporations. With 

respect to such corporations, the provision eliminates the debt-equity threshold generally 

applicable under section 163(j) and reduces the 50-percent thresholds for “excess interest 

expense” and “excess limitation” to 25 percent.

In cases in which a U.S. corporate group acquires subsidiaries or other assets from an 

unrelated inverted corporate group, the provisions described above generally do not apply to the 

acquiring U.S. corporate group or its related parties (including the newly acquired subsidiaries or 
73

assets) by reason of acquiring the subsidiaries or assets that were connected with the inversion 

transaction. The Treasury Secretary is given authority to issue regulations appropriate to carry 

out the purposes of this provision and to prevent its abuse.

Partnership transactions

Under the proposal, both types of inversion transactions include certain partnership 

transactions. Specifically, both parts of the provision apply to transactions in which a foreignincorporated entity acquires substantially all of the properties constituting a trade or business of a 

domestic partnership (whether or not publicly traded), if after the acquisition at least 80 percent 

(or more than 50 percent but less than 80 percent, as the case may be) of the stock of the entity is 

held by former partners of the partnership (by reason of holding their partnership interests), and 

the “substantial business activities” test is not met. For purposes of determining whether these 

tests are met, all partnerships that are under common control within the meaning of section 482 

are treated as one partnership, except as provided otherwise in regulations. In addition, the 

modified “toll charge” provisions apply at the partner level.

Effective Date

The regime applicable to transactions involving at least 80 percent identity of ownership 

applies to inversion transactions completed after March 20, 2002. The rules for inversion 

transactions involving greater-than-50-percent identity of ownership apply to inversion 

transactions completed after 1996 that meet the 50-percent test and to inversion transactions 

completed after 1996 that would have met the 80-percent test but for the March 20, 2002 date. 

2. Excise tax on stock compensation of insiders of inverted corporations

Present Law

The income taxation of a nonstatutory159 compensatory stock option is determined under 

the rules that apply to property transferred in connection with the performance of services (sec.

83). If a nonstatutory stock option does not have a readily ascertainable fair market value at the 

time of grant, which is generally the case unless the option is actively traded on an established 

market, no amount is included in the gross income of the recipient with respect to the option until 

the recipient exercises the option.160 Upon exercise of such an option, the excess of the fair 

market value of the stock purchased over the option price is included in the recipient’s gross 

income as ordinary income in such taxable year. 

 

159 Nonstatutory stock options refer to stock options other than incentive stock options 

and employee stock purchase plans, the taxation of which is determined under sections 421-424. 

160 If an individual receives a grant of a nonstatutory option that has a readily 

ascertainable fair market value at the time the option is granted, the excess of the fair market 

value of the option over the amount paid for the option is included in the recipient’s gross 

income as ordinary income in the first taxable year in which the option is either transferable or 

not subject to a substantial risk of forfeiture.
74

The tax treatment of other forms of stock-based compensation (e.g., restricted stock and 

stock appreciation rights) is also determined under section 83. The excess of the fair market 

value over the amount paid (if any) for such property is generally includable in gross income in 

the first taxable year in which the rights to the property are transferable or are not subject to 

substantial risk of forfeiture. 

Shareholders are generally required to recognize gain upon stock inversion transactions. 

An inversion transaction is generally not a taxable event for holders of stock options and other 

stock-based compensation.

Description of Proposal

Under the provision, specified holders of stock options and other stock-based 

compensation are subject to an excise tax upon certain inversion transactions. The provision 

imposes a 20 percent excise tax on the value of specified stock compensation held (directly or 

indirectly) by or for the benefit of a disqualified individual, or a member of such individual’s 

family, at any time during the 12-month period beginning six months before the corporation’s 

inversion date. Specified stock compensation is treated as held for the benefit of a disqualified 

individual if such compensation is held by an entity, e.g., a partnership or trust, in which the 

individual, or a member of the individual’s family, has an ownership interest.

A disqualified individual is any individual who, with respect to a corporation, is, at any 

time during the 12-month period beginning on the date which is six months before the inversion 

date, subject to the requirements of section 16(a) of the Securities and Exchange Act of 1934 

with respect to the corporation, or any member of the corporation’s expanded affiliated group,161

or would be subject to such requirements if the corporation (or member) were an issuer of equity 

securities referred to in section 16(a). Disqualified individuals generally include officers (as 

defined by section 16(a)),162 directors, and 10-percent owners of private and publicly-held 

corporations.

The excise tax is imposed on a disqualified individual of an inverted corporation only if 

gain (if any) is recognized in whole or part by any shareholder by reason of either the 80 percent 

or 50 percent identity of stock ownership corporate inversion transactions previously described 

in the provision.

 

161 An expanded affiliated group is an affiliated group (under section 1504) except that 

such group is determined without regard to the exceptions for certain corporations and is 

determined applying a greater than 50 percent threshold, in lieu of the 80 percent test.

162 An officer is defined as the president, principal financial officer, principal accounting 

officer (or, if there is no such accounting officer, the controller), any vice-president in charge of 

a principal business unit, division or function (such as sales, administration or finance), any other 

officer who performs a policy-making function, or any other person who performs similar 

policy-making functions.
75

Specified stock compensation subject to the excise tax includes any payment163 (or right 

to payment) granted by the inverted corporation (or any member of the corporation’s expanded 

affiliated group) to any person in connection with the performance of services by a disqualified 

individual for such corporation (or member of the corporation’s expanded affiliated group) if the 

value of the payment or right is based on, or determined by reference to, the value or change in 

value of stock of such corporation (or any member of the corporation’s expanded affiliated 

group). In determining whether such compensation exists and valuing such compensation, all 

restrictions, other than non-lapse restrictions, are ignored. Thus, the excise tax applies, and the 

value subject to the tax is determined, without regard to whether such specified stock 

compensation is subject to a substantial risk of forfeiture or is exercisable at the time of the 

inversion transaction. Specified stock compensation includes compensatory stock and restricted 

stock grants, compensatory stock options, and other forms of stock-based compensation, 

including stock appreciation rights, phantom stock, and phantom stock options. Specified stock 

compensation also includes nonqualified deferred compensation that is treated as though it were 

invested in stock or stock options of the inverting corporation (or member). For example, the 

provision applies to a disqualified individual’s deferred compensation if company stock is one of 

the actual or deemed investment options under the nonqualified deferred compensation plan. 

Specified stock compensation includes a compensation arrangement that gives the 

disqualified individual an economic stake substantially similar to that of a corporate shareholder. 

Thus, the excise tax does not apply where a payment is simply triggered by a target value of the 

corporation’s stock or where a payment depends on a performance measure other than the value 

of the corporation’s stock. Similarly, the tax does not apply if the amount of the payment is not 

directly measured by the value of the stock or an increase in the value of the stock. For example, 

an arrangement under which a disqualified individual is paid a cash bonus of $500,000 if the 

corporation’s stock increased in value by 25 percent over two years or $1,000,000 if the stock 

increased by 33 percent over two years is not specified stock compensation, even though the 

amount of the bonus generally is keyed to an increase in the value of the stock. By contrast, an 

arrangement under which a disqualified individual is paid a cash bonus equal to $10,000 for 

every $1 increase in the share price of the corporation’s stock is subject to the provision because 

the direct connection between the compensation amount and the value of the corporation’s stock 

gives the disqualified individual an economic stake substantially similar to that of a shareholder.

The excise tax applies to any such specified stock compensation previously granted to a 

disqualified individual but cancelled or cashed-out within the six-month period ending with the 

inversion transaction, and to any specified stock compensation awarded in the six-month period 

beginning with the inversion transaction. As a result, for example, if a corporation were to 

cancel outstanding options three months before the transaction and then reissue comparable 

options three months after the transaction, the tax applies both to the cancelled options and the 

newly granted options. It is intended that the Treasury Secretary issue guidance to avoid double 

counting with respect to specified stock compensation that is cancelled and then regranted during 

the applicable twelve-month period.

 

163 Under the provision, any transfer of property is treated as a payment and any right to 

a transfer of property is treated as a right to a payment. 
76

Specified stock compensation subject to the tax does not include a statutory stock option 

or any payment or right from a qualified retirement plan or annuity, a tax-sheltered annuity, a 

simplified employee pension, or a simple retirement account. In addition, under the provision, 

the excise tax does not apply to any stock option that is exercised during the six-month period 

before the inversion or to any stock acquired pursuant to such exercise. The excise tax also does 

not apply to any specified stock compensation which is sold, exchanged, distributed or cashedout during such period in a transaction in which gain or loss is recognized in full.

For specified stock compensation held on the inversion date, the amount of the tax is 

determined based on the value of the compensation on such date. The tax imposed on specified 

stock compensation cancelled during the six-month period before the inversion date is 

determined based on the value of the compensation on the day before such cancellation, while 

specified stock compensation granted after the inversion date is valued on the date granted. 

Under the provision, the cancellation of a non-lapse restriction is treated as a grant. 

The value of the specified stock compensation on which the excise tax is imposed is the 

fair value in the case of stock options (including warrants and other similar rights to acquire 

stock) and stock appreciation rights and the fair market value for all other forms of 

compensation. For purposes of the tax, the fair value of an option (or a warrant or other similar

right to acquire stock) or a stock appreciation right is determined using an appropriate optionpricing model, as specified or permitted by the Treasury Secretary, that takes into account the 

stock price at the valuation date; the exercise price under the option; the remaining term of the 

option; the volatility of the underlying stock and the expected dividends on it; and the risk-free 

interest rate over the remaining term of the option. Options that have no intrinsic value (or 

“spread”) because the exercise price under the option equals or exceeds the fair market value of 

the stock at valuation nevertheless have a fair value and are subject to tax under the provision. 

The value of other forms of compensation, such as phantom stock or restricted stock, are the fair 

market value of the stock as of the date of the inversion transaction. The value of any deferred 

compensation that could be valued by reference to stock is the amount that the disqualified 

individual would receive if the plan were to distribute all such deferred compensation in a single 

sum on the date of the inversion transaction (or the date of cancellation or grant, if applicable). It 

is expected that the Treasury Secretary issue guidance on valuation of specified stock 

compensation, including guidance similar to the revenue procedures issued under section 280G, 

except that the guidance would not permit the use of a term other than the full remaining term. 

Pending the issuance of guidance, it is intended that taxpayers could rely on the revenue 

procedures issued under section 280G (except that the full remaining term must be used). 

The excise tax also applies to any payment by the inverted corporation or any member of 

the expanded affiliated group made to an individual, directly or indirectly, in respect of the tax. 

Whether a payment is made in respect of the tax is determined under all of the facts and 

circumstances. Any payment made to keep the individual in the same after-tax position that the 

individual would have been in had the tax not applied is a payment made in respect of the tax. 

This includes direct payments of the tax and payments to reimburse the individual for payment 

of the tax. It is expected that the Treasury Secretary issue guidance on determining when a 

payment is made in respect of the tax and that such guidance would include certain factors that 

give rise to a rebuttable presumption that a payment is made in respect of the tax, including a 

rebuttable presumption that if the payment is contingent on the inversion transaction, it is made 
77

in respect to the tax. Any payment made in respect of the tax is includible in the income of the 

individual, but is not deductible by the corporation.

To the extent that a disqualified individual is also a covered employee under section 

162(m), the $1,000,000 limit on the deduction allowed for employee remuneration for such 

employee is reduced by the amount of any payment (including reimbursements) made in respect 

of the tax under the provision. As discussed above, this includes direct payments of the tax and 

payments to reimburse the individual for payment of the tax. 

The payment of the excise tax has no effect on the subsequent tax treatment of any 

specified stock compensation. Thus, the payment of the tax has no effect on the individual’s 

basis in any specified stock compensation and no effect on the tax treatment for the individual at 

the time of exercise of an option or payment of any specified stock compensation, or at the time 

of any lapse or forfeiture of such specified stock compensation. The payment of the tax is not 

deductible and has no effect on any deduction that might be allowed at the time of any future 

exercise or payment.

Under the provision, the Treasury Secretary is authorized to issue regulations as may be 

necessary or appropriate to carry out the purposes of the section.

Effective Date

The provision is effective as of July 11, 2002, except that periods before July 11, 2002, 

are not taken into account in applying the tax to specified stock compensation held or cancelled 

during the six-month period before the inversion date.

3. Reinsurance agreements

Present Law

In the case of a reinsurance agreement between two or more related persons, present law 

provides the Treasury Secretary with authority to allocate among the parties or recharacterize 

income (whether investment income, premium or otherwise), deductions, assets, reserves, credits 

and any other items related to the reinsurance agreement, or make any other adjustment, in order 

to reflect the proper source and character of the items for each party.164 For this purpose, related 

persons are defined as in section 482. Thus, persons are related if they are organizations, trades 

or businesses (whether or not incorporated, whether or not organized in the United States, and 

whether or not affiliated) that are owned or controlled directly or indirectly by the same interests. 

The provision may apply to a contract even if one of the related parties is not a domestic 

company.165 In addition, the provision also permits such allocation, recharacterization, or other 

adjustments in a case in which one of the parties to a reinsurance agreement is, with respect to 

 

164 Sec. 845(a).

165 See S. Rep. No. 97-494, “Tax Equity and Fiscal Responsibility Act of 1982,” July 12, 

1982, 337 (describing provisions relating to the repeal of modified coinsurance provisions).
78

any contract covered by the agreement, in effect an agent of another party to the agreement, or a 

conduit between related persons. 

Description of Proposal

The proposal clarifies the rules of section 845, relating to authority for the Treasury 

Secretary to allocate items among the parties to a reinsurance agreement, recharacterize items, or 

make any other adjustment, in order to reflect the proper source and character of the items for 

each party. The proposal authorizes such allocation, recharacterization, or other adjustment, in 

order to reflect the proper source, character or amount of the item. It is intended that this 

authority166 be exercised in a manner similar to the authority under section 482 for the Treasury 

Secretary to make adjustments between related parties. It is intended that this authority be 

applied in situations in which the related persons (or agents or conduits) are engaged in crossborder transactions that require allocation, recharacterization, or other adjustments in order to 

reflect the proper source, character or amount of the item or items. No inference is intended that 

present law does not provide this authority with respect to reinsurance agreements.

No regulations have been issued under section 845(a). It is expected that the Treasury 

Secretary will issue regulations under section 845(a) to address effectively the allocation of 

income (whether investment income, premium or otherwise) and other items, the 

recharacterization of such items, or any other adjustment necessary to reflect the proper amount, 

source or character of the item.

Effective Date

The provision is effective for any risk reinsured after April 11, 2002.

 

166 The authority to allocate, recharacterize or make other adjustments was granted in 

connection with the repeal of provisions relating to modified coinsurance transactions.
79

G. Add Vaccines Against Hepatitis A to the List of Taxable Vaccines

Present Law

A manufacturer’s excise tax is imposed at the rate of 75 cents per dose167 on the 

following vaccines routinely recommended for administration to children: diphtheria, pertussis, 

tetanus, measles, mumps, rubella, polio, HIB (haemophilus influenza type B), hepatitis B, 

varicella (chicken pox), rotavirus gastroenteritis, and streptococcus pneumoniae. The tax applied 

to any vaccine that is a combination of vaccine components equals 75 cents times the number of 

components in the combined vaccine.

Amounts equal to net revenues from this excise tax are deposited in the Vaccine Injury 

Compensation Trust Fund to finance compensation awards under the Federal Vaccine Injury

Compensation Program for individuals who suffer certain injuries following administration of 

the taxable vaccines. This program provides a substitute Federal, “no fault” insurance system for 

the State-law tort and private liability insurance systems otherwise applicable to vaccine 

manufacturers. All persons immunized after September 30, 1988, with covered vaccines must 

pursue compensation under this Federal program before bringing civil tort actions under State 

law.

Description of Proposal

The proposal adds any vaccine against hepatitis A to the list of taxable vaccines. The 

proposal also makes a conforming amendment to the trust fund expenditure purposes. 

Effective Date

The proposal is effective for vaccines sold beginning on the first day of the first month 

beginning more than four weeks after the date of enactment.

 

167 Sec. 4131.
80

H. Disallowance of Certain Partnership Loss Transfers

Present Law

Contributions of property

Under present law, if a partner contributes property to a partnership, generally no gain or 

loss is recognized to the contributing partner at the time of contribution.168 The partnership takes 

the property at an adjusted basis equal to the contributing partner’s adjusted basis in the 

property.169 The contributing partner increases its basis in its partnership interest by the adjusted 

basis of the contributed property.170 Any items of partnership income, gain, loss and deduction 

with respect to the contributed property is allocated among the partners to take into account any 

built-in gain or loss at the time of the contribution.171 This rule is intended to prevent the transfer 

of built-in gain or loss from the contributing partner to the other partners by generally allocating 

items to the noncontributing partners based on the value of their contributions and by allocating 

to the contributing partner the remainder of each item.172 

If the contributing partner transfers its partnership interest, the built-in gain or loss will be 

allocated to the transferee partner as it would have been allocated to the contributing partner.173 

If the contributing partner’s interest is liquidated, there is no specific guidance preventing the 

allocation of the built-in loss to the remaining partners. Thus, it appears that losses can be 

“transferred” to other partners where the contributing partner no longer remains a partner.

Transfers of partnership interests

Under present law, a partnership does not adjust the basis of partnership property 

following the transfer of a partnership interest unless the partnership has made a one-time 

election under section 754 to make basis adjustments.174 If an election is in effect, adjustments 

are made with respect to the transferee partner in order to account for the difference between the 

transferee partner’s proportionate share of the adjusted basis of the partnership property and the 

 

168 Sec. 721.

169 Sec. 723.

170 Sec. 722

171 Sec. 704(c)(1)(A).

172 Where there is an insufficient amount of an item to allocate to the noncontributing 

partners, Treasury regulations allow for reasonable allocations to remedy this insufficiency. 

Treas. Reg. sec. 1-704(c) and (d).

173 Treas. Reg. 1.704-3(a)(7).

174 Sec. 743(a).
81

transferee’s basis in its partnership interest.175 These adjustments are intended to adjust the basis 

of partnership property to approximate the result of a direct purchase of the property by the 

transferee partner. Under these rules, if a partner purchases an interest in a partnership with an 

existing built-in loss and no election under section 754 in effect, the transferee partner may be 

allocated a share of the loss when the partnership disposes of the property (or depreciates the 

property).

Distributions of partnership property

With certain exceptions, partners may receive distributions of partnership property 

without recognition of gain or loss by either the partner or the partnership.176 In the case of a 

distribution in liquidation of a partner’s interest, the basis of the property distributed in the 

liquidation is equal to the partner’s adjusted basis in its partnership interest (reduced by any 

money distributed in the transaction).177 In a distribution other than in liquidation of a partner’s 

interest, the distributee partner’s basis in the distributed property is equal to the partnership’s 

adjusted basis in the property immediately before the distribution, but not to exceed the partner’s 

adjusted basis in the partnership interest (reduced by any money distributed in the same 

transaction).178

Adjustments to the basis of the partnership’s undistributed properties are not required 

unless the partnership has made the election under section 754 to make basis adjustments.179 If 

an election is in effect under section 754, adjustments are made by a partnership to increase or 

decrease the remaining partnership assets to reflect any increase or decrease in the adjusted basis 

of the distributed properties in the hands of the distributee partner.180 To the extent the adjusted 

basis of the distributed properties increases (or loss is recognized) the partnership’s adjusted 

basis in its properties is decreased by a like amount; likewise, to the extent the adjusted basis of 

the distributed properties decrease (or gain is recognized), the partnership’s adjusted basis in its 

properties is increased by a like amount. Under these rules, a partnership with no election in 

effect under section 754 may distribute property with an adjusted basis lower than the distributee 

partner’s proportionate share of the adjusted basis of all partnership property and leave the 

remaining partners with a smaller net built-in gain or a larger net built-in loss than before the 

distribution.

 

175 Sec. 743(b).

176 Sec. 731(a) and (b).

177 Sec. 732(b).

178 Sec. 732(a).

179 Sec. 734(a).

180 Sec. 734(b).
82

Description of Proposal

Contributions of property

Under the proposal, a built-in loss may be taken into account only by the contributing 

partner and not by other partners. Except as provided in regulations, in determining the amount 

of items allocated to partners other than the contributing partner, the basis of the contributed 

property is treated as the fair market value on the date of contribution. Thus, if the contributing 

partner’s partnership interest is transferred or liquidated, the partnership’s adjusted basis in the 

property is based on its fair market value at the date of contribution, and the built-in loss will be 

eliminated.181 

Transfers of partnership interests

The proposal provides that the basis adjustment rules under section 743 are in the case of 

the transfer of a partnership interest with respect to which there is a substantial built-in loss 

(rather than being elective as under present law). For this purpose, a substantial built-in loss 

exists if the transferee partner’s proportionate share of the adjusted basis of the partnership 

property exceeds by more than $250,000 the transferee partner’s basis in the partnership interest 

in the partnership.

Thus, for example, assume that partner A sells his partnership interest to B for its fair 

market value of $1 million. Also assume that B’s proportionate share of the adjusted basis of the 

partnership assets is $1.3 million. Under the bill, section 743(b) applies, so that a $300,000 

decrease is required to the adjusted basis of the partnership assets with respect to B. As a result, 

B would recognize no gain or loss if the partnership immediately sold all its assets for their fair 

market value.

Distribution of partnership property

The proposal provides that the basis adjustments under section 734 are required in the 

case of a distribution with respect to which there is a substantial basis reduction. A substantial 

basis reduction means a downward adjustment of more that $250,000 that would be made to the 

basis of partnership assets if a section 754 election were in effect.

Thus, for example, assume that A and B each contributed $2.5 million to a newly formed 

partnership and C contributed $5 million, and that the partnership purchased LMN stock for $3 

million and XYZ stock for $7 million. Assume that the value of each stock declined to $1 

million. Assume LMN stock is distributed to C in liquidation of its partnership interest. As 

under present law, the basis of LMN stock in C’s hands is $5 million. Under present law, C 

would recognize a loss of $4 million if the LMN stock were sold for $1 million.

 

181 It is intended that a corporation succeeding to attributes of the contributing corporate 

partner under section 381 shall be treated in the same manner as the contributing partner.
83

Under the proposal, however, there is a substantial basis adjustment because the $2 

million increase in the adjusted basis of LMN stock (sec. 734(b)(2)(B)) is greater than $250,000. 

Thus, the partnership is required to decrease the basis of XYZ stock (under section 734(b)(2)) by 

$2 million (the amount by which the basis LMN stock was increased), leaving a basis of $5 

million. If the XYZ stock were then sold by the partnership for $1 million, A and B would each 

recognize a loss of $2 million.

 Effective Date

The proposal applies to contributions, transfers, and distributions (as the case may be) 

after the date of enactment.
84

I. Treatment of Stripped Bonds to Apply to Stripped

Interests in Bond and Preferred Stock Funds

Present Law

Assignment of income in general

In general, an “income stripping” transaction involves a transaction in which the right to 

receive future income from income-producing property is separated from the property itself. In 

such transactions, it may be possible to generate artificial losses from the disposition of certain 

property or to defer the recognition of taxable income associated with such property. 

Common law has developed a rule (referred to as the “assignment of income” doctrine) 

that income may not be transferred without also transferring the underlying property. A leading 

judicial decision relating to the assignment of income doctrine involved a case in which a 

taxpayer made a gift of detachable interest coupons before their due date while retaining the 

bearer bond. The U.S. Supreme Court ruled that the donor was taxable on the entire amount of 

interest when paid to the donee on the grounds that the transferor had “assigned” to the donee the 

right to receive the income.182

In addition to general common law assignment of income principles, specific statutory 

rules have been enacted to address certain specific types of stripping transactions, such as 

transactions involving stripped bonds and stripped preferred stock (which are discussed 

below).183 However, there are no specific statutory rules that address stripping transactions with 

respect to common stock or other equity interests (other than preferred stock).184 

Both the scope of the assignment of income doctrine and the extent to which the doctrine

has been overruled by the subsequent enactment of specific statutory income stripping rules is 

unclear.

 

182

 Helvering v. Horst, 311 U.S. 112 (1940).

183 Depending on the facts, the IRS also could determine that a variety of other Codebased and common law-based authorities could apply to income stripping transactions, 

including: (1) sections 269, 382, 446(b), 482, 701, or 704 and the regulations thereunder; (2) 

authorities that recharacterize certain assignments or accelerations of future payments as 

financings; (3) business purpose, economic substance, and sham transaction doctrines; (4) the 

step transaction doctrine; and (5) the substance-over-form doctrine. See Notice 95-53, 1995-2 

C.B. 334 (accounting for lease strips and other stripping transactions).

184 However, in Estate of Stranahan v. Commissioner, 472 F.2d 867 (6th Cir. 1973), the 

court held that where a taxpayer sold a carved-out interest of stock dividends, with no personal 

obligation to produce the income, the transaction was treated as a sale of an income interest.
85

Stripped bonds

Special rules are provided with respect to the purchaser and “stripper” of stripped 

bonds.185 A “stripped bond” is defined as a debt instrument in which there has been a separation 

in ownership between the underlying debt instrument and any interest coupon that has not yet 

become payable.186 In general, upon the disposition of either the stripped bond or the detached 

interest coupons, the retained portion and the portion that is disposed of each is treated as a new 

bond that is purchased at a discount and is payable at a fixed amount on a future date. 

Accordingly, section 1286 treats both the stripped bond and the detached interest coupons as

individual bonds that are newly issued with original issue discount (“OID”) on the date of 

disposition. Consequently, section 1286 effectively subjects the stripped bond and the detached 

interest coupons to the general OID periodic income inclusion rules.

A taxpayer who purchases a stripped bond or one or more stripped coupons is treated as 

holding a new bond that is issued on the purchase date with OID in an amount that is equal to the 

excess of the stated redemption price at maturity (or in the case of a coupon, the amount payable 

on the due date) over the ratable share of the purchase price of the stripped bond or coupon, 

determined on the basis of the respective fair market values of the stripped bond and coupons on 

the purchase date.187 The OID on the stripped bond or coupon is includible in gross income 

under the general OID periodic income inclusion rules.

A taxpayer who strips a bond and disposes of either the stripped bond or one or more 

stripped coupons must allocate his basis, immediately before the disposition, in the bond (with 

the coupons attached) between the retained and disposed items.188 Special rules apply to require 

that interest or market discount accrued on the bond prior to such disposition must be included in 

the taxpayer’s gross income (to the extent that it had not been previously included in income) at 

the time the stripping occurs, and the taxpayer increases his basis in the bond by the amount of 

such accrued interest or market discount. The adjusted basis (as increased by any accrued 

interest or market discount) is then allocated between the stripped bond and the stripped interest 

coupons in relation to their respective fair market values. Amounts realized from the sale of 

stripped coupons or bonds constitute income to the taxpayer only to the extent such amounts 

exceed the basis allocated to the stripped coupons or bond. With respect to retained items (either 

the detached coupons or stripped bond), to the extent that the price payable on maturity, or on the 

due date of the coupons, exceeds the portion of the taxpayer’s basis allocable to such retained 

 

185 Section 1286.

186 Section 1286(e).

187 Section 1286(a).

188 Section 1286(b). Similar rules apply in the case of any person whose basis in any 

bond or coupon is determined by reference to the basis in the hands of a person who strips the 

bond.
86

items, the difference is treated as OID that is required to be included under the general OID 

periodic income inclusion rules.189

Stripped preferred stock

“Stripped preferred stock” is defined as preferred stock in which there has been a 

separation in ownership between such stock and any dividend on such stock that has not become 

payable.190 A taxpayer who purchases stripped preferred stock is required to include in gross 

income, as ordinary income, the amounts that would have been includible if the stripped 

preferred stock was a bond issued on the purchase date with OID equal to the excess of the 

redemption price of the stock over the purchase price.191 This treatment is extended to any 

taxpayer whose basis in the stock is determined by reference to the basis in the hands of the 

purchaser. A taxpayer who strips and disposes the future dividends is treated as having 

purchased the stripped preferred stock on the date of such disposition for a purchase price equal 

to the taxpayer’s adjusted basis in the stripped preferred stock.192

Description of Proposal

The proposal authorizes the Treasury Department to promulgate regulations that, in 

appropriate cases, apply rules that are similar to the present-law rules for stripped bonds and 

stripped preferred stock to direct or indirect interests in an entity or account substantially all of 

the assets of which consist of bonds (as defined in section 1286(e)(1)), preferred stock (as 

defined in section 305(e)(5)(B)), or any combination thereof. The proposal applies only to cases 

in which the present-law rules for stripped bonds and stripped preferred stock do not already 

apply to such interests.

For example, such Treasury regulations could apply to a transaction in which a person 

effectively strips future dividends from shares in a money market mutual fund (and disposes 

either the stripped shares or stripped future dividends) by contributing the shares (with the future 

dividends) to a custodial account through which another person purchases rights to either the 

stripped shares or the stripped future dividends. However, it is intended that Treasury 

regulations issued under this proposal would not apply to certain transactions involving direct or 

indirect interests in an entity or account substantially all the assets of which consist of taxexempt obligations (as defined in section 1275(a)(3)), such as a tax-exempt bond partnership 

described in Rev. Proc. 2002-68, 2002-43 I.R.B. 753, modifying and superceding Rev. Proc. 

2002-16, 2002-9 I.R.B. 572.

 

189 Special rules are provided with respect to stripping transactions involving tax-exempt 

obligations that treat OID (computed under the stripping rules) in excess of OID computed on 

the basis of the bond’s coupon rate (or higher rate if originally issued at a discount) as income 

from a non-tax-exempt debt instrument (sec. 1286(d)).

190 Section 305(e)(5).

191 Section 305(e)(1).

192 Section 305(e)(3).
87

No inference is intended as to the treatment under the present-law rules for stripped 

bonds and stripped preferred stock, or under any other provisions or doctrines of present law, of 

interests in an entity or account substantially all of the assets of which consist of bonds, preferred 

stock, or any combination thereof. The Treasury regulations, when issued, would be applied 

prospectively, except in cases to prevent abuse.

Effective Date

The proposal is effective for purchases and dispositions occurring after the date of 

enactment.
88

J. Reporting of Taxable Mergers and Acquisitions

Present Law

Under section 6045 and the regulations thereunder, brokers (defined to include stock 

transfer agents) are required to make information returns and to provide corresponding payee 

statements as to sales made on behalf of their customers, subject to the penalty provisions of 

sections 6721-6724. Under the regulations issued under section 6045, this requirement generally 

does not apply with respect to taxable transactions other than exchanges for cash (e.g., stock 

inversion transactions taxable to shareholders by reason of section 367(a)).

Description of Proposal

Under the proposal, if gain or loss is recognized in whole or in part by shareholders of a 

corporation by reason of a second corporation’s acquisition of the stock or assets of the first 

corporation, then the acquiring corporation (or the acquired corporation, if so prescribed by the 

Treasury Secretary) is required to make a return containing: 

(1) A description of the transaction;

(2) The name and address of each shareholder of the acquired corporation that 

recognizes gain as a result of the transaction (or would recognize gain, if there 

was a built-in gain on the shareholder’s shares);

(3) The amount of money and the value of stock or other consideration paid to each 

shareholder described above; and

(4) Such other information as the Treasury Secretary may prescribe.

Alternatively, a stock transfer agent who records transfers of stock in such transaction 

may make the return described above in lieu of the second corporation.

In addition, every person required to make a return described above is required to furnish 

to each shareholder whose name is required to be set forth in such return a written statement 

showing:

(1) The name, address, and phone number of the information contact of the person 

required to make such return;

(2) The information required to be shown on that return; and

(3) Such other information as the Treasury Secretary may prescribe.

This written statement is required to be furnished to the shareholder on or before January 

31 of the year following the calendar year during which the transaction occurred.

The present-law penalties for failure to comply with information reporting requirements 

are extended to failures to comply with the requirements set forth under this proposal.
89

Effective Date

The proposal is effective for acquisitions after the date of enactment of the proposal.
90

K. Inclusion in Gross Income of Certain Deferred Compensation

Present Law

The determination of when amounts deferred under a nonqualified deferred compensation 

arrangement are includible in the gross income of the individual earning the compensation 

depends on the facts and circumstances of the arrangement. A variety of tax principles and Code 

provisions may be relevant in making this determination, including the doctrine of constructive 

receipt, the economic benefit doctrine,193 the provisions of section 83 relating generally to 

transfers of property in connection with the performance of services, and provisions relating 

specifically to nonexempt employee trusts (sec. 402(b)) and nonqualified annuities (sec. 403(c)).

In general, the time for income inclusion of nonqualified deferred compensation depends 

on whether the arrangement is unfunded or funded. If the arrangement is unfunded, then the 

compensation is generally includible in income when it is actually or constructively received. If 

the arrangement is funded, then income is includible for the year in which the individual’s rights 

are transferable or not subject to a substantial risk of forfeiture.

Nonqualified deferred compensation is generally subject to social security and Medicare 

tax when it is earned (i.e., when services are performed), unless the nonqualified deferred 

compensation is subject to a substantial risk of forfeiture. If nonqualified deferred compensation 

is subject to a substantial risk of forfeiture, it is subject to social security and Medicare tax when 

the risk of forfeiture is removed (i.e., when the right to the nonqualified deferred compensation 

vests). This treatment is not affected by whether the arrangement is funded or unfunded, which 

is relevant in determining when amounts are includible in income (and subject to income tax 

withholding).

In general, an arrangement is considered funded if there has been a transfer of property 

under section 83. Under that section, a transfer of property occurs when a person acquires a 

beneficial ownership interest in such property. The term “property” is defined very broadly for 

purposes of section 83.194 Property includes real and personal property other than money or an 

unfunded and unsecured promise to pay money in the future. Property also includes a beneficial 

interest in assets (including money) that are transferred or set aside from claims of the creditors 

of the transferor, for example, in a trust or escrow account. Accordingly, if, in connection with 

the performance of services, vested contributions are made to a trust on an individual’s behalf 

and the trust assets may be used solely to provide future payments to the individual, the payment 

of the contributions to the trust constitutes a transfer of property to the individual that is taxable 

under section 83. On the other hand, deferred amounts are generally not includible in income in 

situations where nonqualified deferred compensation is payable from general corporate funds 

 

193

 See, e.g., Sproull v. Commissioner, 16 T.C. 244 (1951), aff’d per curiam, 194 F.2d 

541 (6th Cir. 1952); Rev. Rul. 60-31, 1960-1 C.B. 174.

194 Treas. Reg. sec. 1.83-3(e). This definition in part reflects previous IRS rulings on 

nonqualified deferred compensation.
91

that are subject to the claims of general creditors, as such amounts are treated as unfunded and 

unsecured promises to pay money or property in the future.

As discussed above, if the arrangement is unfunded, then the compensation is generally 

includible in income when it is actually or constructively received under section 451. Income is 

constructively received when it is credited to an individual’s account, set apart, or otherwise 

made available so that it can be drawn on at any time. Income is not constructively received if 

the taxpayer’s control of its receipt is subject to substantial limitations or restrictions. A 

requirement to relinquish a valuable right in order to make withdrawals is generally treated as a 

substantial limitation or restriction.

Special statutory provisions govern the timing of the deduction for nonqualified deferred 

compensation, regardless of whether the arrangement covers employees or nonemployees and 

regardless of whether the arrangement is funded or unfunded.195 Under these provisions, the 

amount of nonqualified deferred compensation that is includible in the income of the individual 

performing services is deductible by the service recipient for the taxable year in which the 

amount is includible in the individual’s income.

Rabbi trusts 

Arrangements have developed in an effort to provide employees with security for 

nonqualified deferred compensation, while still allowing deferral of income inclusion. A “rabbi 

trust” is a trust or other fund established by the employer to hold assets from which nonqualified 

deferred compensation payments will be made. The trust or fund is generally irrevocable and 

does not permit the employer to use the assets for purposes other than to provide nonqualified 

deferred compensation, except that the terms of the trust or fund provide that the assets are 

subject to the claims of the employer’s creditors in the case of insolvency or bankruptcy.

As discussed above, for purposes of section 83, property includes a beneficial interest in 

assets set aside from the claims of creditors, such as in a trust or fund, but does not include an 

unfunded and unsecured promise to pay money in the future. In the case of a rabbi trust, terms 

providing that the assets are subject to the claims of creditors of the employer in the case of 

insolvency or bankruptcy have been the basis for the conclusion that the creation of a rabbi trust 

does not cause the related nonqualified deferred compensation arrangement to be funded for 

income tax purposes.196 As a result, no amount is included in income by reason of the rabbi 

trust; generally income inclusion occurs as payments are made from the trust.

The IRS has issued guidance setting forth model rabbi trust provisions.197 Revenue 

Procedure 92-64 provides a safe harbor for taxpayers who adopt and maintain grantor trusts in 

 

195 Secs. 404(a)(5), (b) and (d) and sec. 83(h).

196 This conclusion was first provided in a 1980 private ruling issued by the IRS with 

respect to an arrangement covering a rabbi; hence the popular name “rabbi trust.” Priv. Ltr. Rul. 

8113107 (Dec. 31, 1980).

197 Rev. Proc. 92-64, 1992-2 C.B. 422, modified in part by Notice 2000-56, 2000-2 C.B. 

393.
92

connection with unfunded deferred compensation arrangements. The model trust language 

requires that the trust provide that all assets of the trust are subject to the claims of the general 

creditors of the company in the event of the company’s insolvency or bankruptcy. 

Since the concept of rabbi trusts was developed, arrangements have developed which 

attempt to protect the assets from creditors despite the terms of the trust. Arrangements also 

have developed which effectively allow deferred amounts to be available to participants, while 

still meeting the safe harbor requirements set forth by the IRS.

Description of Proposal

Under the proposal, amounts deferred under a nonqualified deferred compensation 

plan198 are currently includible in income unless certain requirements are satisfied. Distributions 

from nonqualified deferred compensation arrangements can only be distributed upon separation 

from service, disability, death, a specified time, change in control, or financial hardship. The 

deferred compensation plan cannot permit the acceleration of the time of such payment by reason 

of any event. Separation from service distributions to disqualified individuals (as defined in 

section 280G) cannot be made earlier than six months after the date of separation from service. 

Amounts payable upon the occurrence of an event are not treated as amounts payable at a 

specified time. For example, amounts payable when an individual attains age 65 are payable at a 

specified time, while amounts payable when an individual’s child begins college are payable 

upon the occurrence of an event. 

Disability is defined as under the Social Security Act. Under such definition, an 

individual is considered to be disabled if he is unable to engage in any substantial gainful activity 

by reason of any medically determinable physical or mental impairment which can be expected 

to result in death or which has lasted or can be expected to last for a continuous period of not less 

than twelve months.

Financial hardship is defined as severe financial hardship of the participant or beneficiary 

resulting from an illness or accident of the participant or beneficiary, the participant’s or 

beneficiary’s spouse or the participant’s or beneficiary’s dependent (as defined in 152(a)); loss of 

the participant’s or beneficiary’s property due to casualty; or other similar extraordinary and 

unforeseeable circumstances arising as a result of events beyond the control of the participant or 

beneficiary. The amount of the distribution must be limited to the amount needed to satisfy the 

hardship plus taxes. Distributions can not be allowed to the extent that the hardship may be 

relieved through reimbursement or compensation by insurance or otherwise, or by liquidation of 

the participant’s assets (to the extent such liquidation would not itself cause financial hardship).

Under the proposal, change in control will be defined by the Secretary.

Initial deferrals must be required to be made no later than prior to the beginning of the 

taxable year that the compensation is earned. In the first year that an employee becomes eligible 

for participation in the plan, the election can be made within 30 days after the date that the 

 

198 A plan includes an agreement or arrangement.
93

employee is initially eligible. Subsequent elections to delay the timing or form of payment can 

be permitted only if the subsequent election is made more than 12 months prior to the date of the 

scheduled distribution and provides additional deferral for a period of not less than 5 years. A 

participant cannot be allowed to make more than one subsequent election. No accelerations can 

be allowed. 

If impermissible distributions or elections are made, or if the plan or arrangement is 

amended to allow for impermissible distributions or elections, amounts deferred are currently 

includible in income. If the requirements of the proposal are not satisfied, in addition to current 

income inclusion, interest at the underpayment rate plus one percentage point is imposed on the 

underpayments that would have occurred had the compensation been includible in income when 

first deferred. Interest imposed under the proposal is treated as interest on an underpayment of 

tax. Earnings on amounts deferred are also subject to the proposal.

Under the proposal, amounts deferred through an offshore trust are currently includible in 

income. In addition, amounts deferred under a nonqualified deferred compensation arrangement 

that provides that upon a change in the employer’s financial health, assets will be restricted to the 

payment of deferred compensation would also be currently includible in income. The rule is 

violated upon the earlier of when the assets are so restricted or when the plan provides that assets 

will be restricted. Interest at the underpayment rate plus one percentage point is also imposed on 

the underpayments that would have occurred had the amounts deferred in an offshore trust or 

arrangement with financial trigger been includible in income for the taxable year such amounts 

were first set aside.

A nonqualified deferred compensation plan is any plan that provides for the deferral of 

compensation other than a qualified retirement plan. 

Annual reporting to the IRS of amounts deferred is required under the proposal. 

Amounts deferred are required to be reported on an individual’s Form W-2 for the year deferred 

even if the amount is not currently includible in income for that taxable year. 

The proposal is not intended to preclude the application of other rules that would require 

earlier income inclusion. The proposal provides the Secretary of the Treasury authority to 

prescribe regulations as are necessary to carry out the proposal. 

Effective Date

The proposal is effective for amounts deferred in taxable years beginning after December 

31, 2003.
94

L. Minimum Holding Period for Foreign Tax Credit with respect to Withholding Taxes on 

Income other than Dividends

Present Law

In general, U.S. persons may credit foreign taxes against U.S. tax on foreign-source 

income. The amount of foreign tax credits that may be claimed in a year is subject to a limitation 

that prevents taxpayers from using foreign tax credits to offset U.S. tax on U.S.-source income. 

Separate limitations are applied to specific categories of income.

As a consequence of the foreign tax credit limitations of the Code, certain taxpayers are 

unable to utilize their creditable foreign taxes to reduce their U.S. tax liability. U.S. taxpayers 

that are tax-exempt receive no U.S. tax benefit for foreign taxes paid on income that they 

receive.

Present law denies a U.S. shareholder the foreign tax credits normally available with 

respect to a dividend from a corporation or a regulated investment company (“RIC”) if the 

shareholder has not held the stock for more than 15 days (within a 30-day testing period) in the 

case of common stock or more than 45 days (within a 90-day testing period) in the case of 

preferred stock (sec. 901(k)). The disallowance applies both to foreign tax credits for foreign 

withholding taxes that are paid on the dividend where the dividend-paying stock is held for less 

than these holding periods, and to indirect foreign tax credits for taxes paid by a lower-tier 

foreign corporation or a RIC where any of the required stock in the chain of ownership is held 

for less than these holding periods. Periods during which a taxpayer is protected from risk of 

loss (e.g., by purchasing a put option or entering into a short sale with respect to the stock) 

generally are not counted toward the holding period requirement. In the case of a bona fide 

contract to sell stock, a special rule applies for purposes of indirect foreign tax credits. The 

disallowance does not apply to foreign tax credits with respect to certain dividends received by 

active dealers in securities. If a taxpayer is denied foreign tax credits because the applicable 

holding period is not satisfied, the taxpayer is entitled to a deduction for the foreign taxes for 

which the credit is disallowed.

Description of Proposal

The proposal expands the present-law disallowance of foreign tax credits to include 

credits for gross-basis foreign withholding taxes with respect to any item of income or gain from 

property if the taxpayer who receives the income or gain has not held the property for more than 

15 days (within a 30-day testing period), exclusive of periods during which the taxpayer is 

protected from risk of loss. The proposal does not apply to foreign tax credits that are subject to 

the present-law disallowance with respect to dividends. The proposal also does not apply to 

certain income or gain that is received with respect to property held by active dealers. Rules 

similar to the present-law disallowance for foreign tax credits with respect to dividends apply to 

foreign tax credits that are subject to the proposal. In addition, the proposal authorizes the 

Treasury Department to issue regulations providing that the proposal does not apply in 

appropriate cases.
95

Effective Date

The provision is effective for amounts that are paid or accrued more than 30 days after 

the date of enactment.
96

M. Permit Private Sector Debt Collection Companies to Collect Tax Debts

Present Law

In fiscal years 1996 and 1997, the Congress earmarked $13 million for IRS to test the use 

of private debt collection companies. There were several constraints on this pilot project. First, 

because both IRS and OMB considered the collection of taxes to be an inherently governmental 

function, only government employees were permitted to collect the taxes. The private debt 

collection companies were utilized to assist the IRS in locating and contacting taxpayers, 

reminding them of their outstanding tax liability, and suggesting payment options. If the 

taxpayer agreed at that point to make a payment, the taxpayer was transferred from the private 

debt collection company to the IRS. Second, the private debt collection companies were paid a 

flat fee for services rendered; the amount that was ultimately collected by the IRS was not taken 

into account in the payment mechanism.

The pilot program was discontinued because of disappointing results. GAO reported199

that IRS collected $3.1 million attributable to the private debt collection company efforts; 

expenses were also $3.1 million. In addition, there were lost opportunity costs of $17 million to 

the IRS because collection personnel were diverted from their usual collection responsibilities to 

work on the pilot.

The IRS has recently revised its extensive Request for Information concerning its 

possible use of private debt collection companies.200 

In general, Federal agencies are permitted to enter into contracts with private debt 

collection companies for collection services to recover indebtedness owed to the United 

States.201 That provision does not apply to the collection of debts under the Internal Revenue 

Code.202 

Description of Proposal

The proposal permits the IRS to use private debt collection companies to locate and 

contact taxpayers owing outstanding tax liabilities and to arrange payment of those taxes by the 

taxpayers. Several steps are involved. First, the private debt collection company contacts the 

taxpayer by letter.203 If the taxpayer’s last known address is incorrect, the private debt collection 

 

199 GAO/GGD-97-129R Issues Affecting IRS’ Collection Pilot (July 18, 1997).

200 TIRNO-03-H-0001 (February 14, 2003), at www.procurement.irs.treas.gov. The 

basic request for information is 104 pages, and there are 16 additional attachments.

201 31 U.S.C. 3718.

202 31 U.S.C. 3718(f).

203 Several portions of the proposal require that the IRS disclose confidential taxpayer 

information to the private debt collection company. Section 6103(n) permits disclosure for “the 
97

company searches for the correct address. The private debt collection company is not permitted 

to contact either individuals or employers to locate a taxpayer. Second, the private debt 

collection company telephones the taxpayer to request full payment.204 If the taxpayer cannot 

pay in full immediately, the private debt collection company offers the taxpayer an installment 

agreement providing for full payment of the taxes over a period of up to three years. If the 

taxpayer is unable to pay the outstanding tax liability in full over a three-year period, the private 

debt collection company obtains financial information from the taxpayer and will provide this 

information to the IRS for further processing and action by the IRS.

The proposal specifies several procedural conditions under which the proposal would 

operate. First, provisions of the Fair Debt Collection Act apply to the private debt collection 

company.205 Second, taxpayer protections that are statutorily applicable to the IRS are also made 

statutorily applicable to the private sector debt collection companies. Third, the private sector 

debt collection companies are required to inform taxpayers of the availability of assistance from 

the Taxpayer Advocate.

The proposal creates a revolving fund from the amounts collected by the private debt 

collection companies. The private debt collection companies are paid out of this fund. Their 

compensation would be “based upon a number of factors, including quality of service, taxpayer 

satisfaction, and case resolution, in addition to collection results.”206

Effective Date

The proposal is effective after the date of enactment.

 

providing of other services ... for purposes of tax administration.” Accordingly, no amendment 

to 6103 is necessary to implement the proposal.

204 It is anticipated that the private debt collection company will not accept payment 

directly; payments will be processed by IRS employees.

205 This is present law.

206 Treasury General Explanations, p. 99.
98

N. Repeal the exclusion for foreign earned income and

the exclusion or deduction for housing expenses

Present Law

U.S. citizens generally are subject to U.S. income tax on all their income, whether 

derived in the United States or elsewhere. A U.S. citizen who earns income in a foreign country 

also may be taxed on such income by that foreign country. However, the United States generally 

cedes the primary right to tax income derived by a U.S. citizen from sources outside the United 

States to the foreign country where such income is derived. Accordingly, a credit against the 

U.S. income tax imposed on foreign source taxable income is provided for foreign taxes paid on 

that income.

U.S. citizens living abroad may be eligible to exclude from their income for U.S. tax 

purposes certain foreign earned income and foreign housing costs. In order to qualify for these 

exclusions, a U.S. citizen must be either: (1) a bona fide resident of a foreign country for an 

uninterrupted period that includes an entire taxable year; or (2) present overseas for 330 days out 

of any 12-consecutive-month period. In addition, the taxpayer must have his or her tax home in 

a foreign country.

The exclusion for foreign earned income generally applies to income earned from sources 

outside the United States as compensation for personal services actually rendered by the 

taxpayer. The maximum exclusion for foreign earned income for a taxable year is $80,000 (for

2002 and thereafter). For taxable years beginning after 2007, the maximum exclusion amount is 

indexed for inflation.

The exclusion for housing costs applies to reasonable expenses, other than deductible 

interest and taxes, paid or incurred by or on behalf of the taxpayer for housing for the taxpayer 

and his or her spouse and dependents in a foreign country. The exclusion amount for housing 

costs for a taxable year is equal to the excess of such housing costs for the taxable year over an 

amount computed pursuant to a specified formula. In the case of housing costs that are not paid 

or reimbursed by the taxpayer's employer, the amount that would be excludible is treated instead 

as a deduction.

The combined earned income exclusion and housing cost exclusion may not exceed the 

taxpayer’s total foreign earned income. The taxpayer’s foreign tax credit is reduced by the 

amount of such credit that is attributable to excluded income.

Special exclusions apply in the case of taxpayers who reside in one of the U.S. 

possessions.

Description of the Proposal

The proposal repeals the exclusion for foreign earned income and the exclusion or 

deduction for housing expenses.
99

Effective Date

The proposal is effective for taxable years beginning after December 31, 2004.
100

O. Modify Qualification Rules for Tax-Exempt 

Property and Casualty Insurance Companies

Present Law

A property and casualty insurance company is eligible to be exempt from Federal income 

tax if its net written premiums or direct written premiums (whichever is greater) for the taxable 

year do not exceed $350,000 (sec. 501(c)(15)).

A property and casualty insurance company may elect to be taxed only on taxable 

investment income if its net written premiums or direct written premiums (which ever greater) 

for the taxable year exceed $350,000, but do not exceed $1.2 million (sec. 831(b)).

For purposes of determining the amount of company's net written premiums or direct 

written premiums under these rules, premiums received by all members of a controlled group of 

corporations of which the company is a part are taken into account. For this purpose, a morethan-50-percent threshhold applies under the vote and value requirements with respect to stock 

ownership for determining a controlled group, and rules treating a life insurance company as part 

of a separate controlled group or as an excluded member of a group do not apply (secs. 

501(c)(15), 831(b)(2)(B) and 1563).

Description of Proposal

The proposal modifies the requirements for a property and casualty insurance company to 

be eligible for tax-exempt status, and to elect to be taxed only on taxable investment income. 

Under the proposal, a property and casualty insurance company is eligible to be exempt 

from Federal income tax if (a) its gross receipts for the taxable year do not exceed $600,000, and 

(b) the premiums received for the taxable year are greater than 50 percent of the gross receipts. 

For purposes of determining gross receipts, the gross receipts of all members of a controlled 

group of corporations of which the company is a part are taken into account.

The proposal also provides that a property and casualty insurance company may elect to 

be taxed only on taxable investment income if its net written premiums or direct written 

premiums (whichever is greater) do not exceed $1.2 million (without regard to whether such 

premiums exceed $350,000). The proposal retains the present-law rule that, for purposes of 

determining the amount of company's net written premiums or direct written premiums under 

this rule, premiums received by all members of a controlled group of corporations of which the 

company is a part are taken into account.

Effective Date

The proposal is effective for taxable years beginning after December 31, 2003.
101

P. Authorize IRS to Enter into Installment Agreements

that Provide for Partial Payment

Present Law

The Code authorizes the IRS to enter into written agreements with any taxpayer under 

which the taxpayer is allowed to pay taxes owed, as well as interest and penalties, in installment 

payments if the IRS determines that doing so will facilitate collection of the amounts owed (sec. 

6159). An installment agreement does not reduce the amount of taxes, interest, or penalties 

owed. Generally, during the period installment payments are being made, other IRS enforcement 

actions (such as levies or seizures) with respect to the taxes included in that agreement are held 

in abeyance. 

Prior to 1998, the IRS administratively entered into installment agreements that provided 

for partial payment (rather than full payment) of the total amount owed over the period of the 

agreement. In that year, the IRS Chief Counsel issued a memorandum concluding that partial 

payment installment agreements were not permitted.

Description of Proposal

The proposal clarifies that the IRS is authorized to enter into installment agreements with 

taxpayers which do not provide for full payment of the taxpayer’s liability over the life of the 

agreement. The proposal also requires the IRS to review partial payment installment agreements 

at least every two years. The primary purpose of this review is to determine whether the 

financial condition of the taxpayer has significantly changed so as to warrant an increase in the 

value of the payments being made.

Effective Date

The proposal is effective for installment agreements entered into on or after the date of 

enactment. 
102

Q. Denial of Deduction for Certain Fines, Penalties, and Other Amounts 

Present Law

Under present law, no deduction is allowed as a trade or business expense under section 

162(a) for the payment of a fine or similar penalty to a government for the violation of any law 

(sec. 162(f)). The enactment of section 162(f) in 1969 codified existing case law that denied the 

deductibility of fines as ordinary and necessary business expenses on the grounds that 

“allowance of the deduction would frustrate sharply defined national or State policies proscribing 

the particular types of conduct evidenced by some governmental declaration thereof.”207

Treasury regulation section 1.162-21(b)(1) provides that a fine or similar penalty includes 

an amount: (1) paid pursuant to conviction or a plea of guilty or nolo contendere for a crime 

(felony or misdemeanor) in a criminal proceeding; (2) paid as a civil penalty imposed by Federal, 

State, or local law, including additions to tax and additional amounts and assessable penalties 

imposed by chapter 68 of the Code; (3) paid in settlement of the taxpayer’s actual or potential 

liability for a fine or penalty (civil or criminal); or (4) forfeited as collateral posted in connection 

with a proceeding which could result in imposition of such a fine or penalty. Treasury regulation 

section 1.162-21(b)(2) provides, among other things, that compensatory damages (including 

damages under section 4A of the Clayton Act (15 U.S.C. 15a), as amended) paid to a 

government do not constitute a fine or penalty. 

Description of Proposal

The proposal modifies the rules regarding the determination whether payments are 

nondeductible payments of fines or penalties under section 162(f). In particular, the proposal 

generally provides that amounts paid or incurred (whether by suit, agreement, or otherwise) to, 

or at the direction of, a government in relation to the violation of any law or the investigation or 

inquiry into the potential violation of any law are nondeductible under any provision of the 

income tax provisions.208 The proposal applies to deny a deduction for any such payments, 

including those where there is no admission of guilt or liability and those made for the purpose 

of avoiding further investigation or litigation. An exception applies to payments that the 

taxpayer establishes are restitution.209

 It is intended that a payment will be treated as restitution only if the payment is required 

to be paid to the specific persons, or in relation to the specific property, actually harmed by the 

conduct of the taxpayer that resulted in the payment. Thus, a payment to or with respect to a 

 

207 S. Rep. 91-552, 91st Cong, 1st Sess., 273-74 (1969), referring to Tank Truck Rentals, 

Inc. v. Commissioner, 356 U.S. 30 (1958). 

208 The proposal provides that such amounts are nondeductible under chapter 1 of the 

Internal Revenue Code. 

209 The proposal does not affect the treatment of antitrust payments made under section 4 

of the Clayton Act, which will continue to be governed by the provisions of section 162(g). 
103

class broader than the specific persons or property that were actually harmed (e.g., to a class 

including similarly situated persons or property) does not qualify as restitution.210 Restitution is 

limited to the amount that bears a substantial quantitative relationship to the harm caused by the 

past conduct or actions of the taxpayer that resulted in the payment in question. If the party 

harmed is a government or other entity, then restitution includes payment to such harmed 

government or entity, provided the payment bears a substantial quantitative relationship to the 

harm. However, restitution does not include reimbursement of government investigative or 

litigation costs, or payments to whistleblowers.

Amounts paid or incurred to, or at the direction of, any self-regulatory entity that 

regulates a financial market or other market that is a qualified board or exchange under section 

1256(g)(7), and that is authorized to impose sanctions (e.g., the National Association of 

Securities Dealers) are subject to the proposal. To the extent provided in regulations, amounts 

paid or incurred to, or at the direction of, any other nongovernmental entity that exercises selfregulatory powers as part of performing an essential governmental function are also subject to 

the provision. 

No inference is intended as to the treatment of payments as nondeductible fines or 

penalties under present law. In particular, the bill is not intended to limit the scope of presentlaw section 162(f) or the regulations thereunder. 

Effective Date

The proposal is effective for amounts paid or incurred on or after April 28, 2003; 

however the proposal does not apply to amounts paid or incurred under any binding order or 

agreement entered into before such date. Any order or agreement requiring court approval is not 

a binding order or agreement for this purpose unless such approval was obtained on or before 

April 27, 2003.

 

210 Similarly, a payment to a charitable organization benefitting a broader class than the 

persons or property actually harmed, or to be paid out without a substantial quantitative 

relationship to the harm caused, would not qualify as restitution. Under the proposal, such a 

payment not deductible under section 162 would also not be deductible under section 170. 
104

R. Deposits Made to Suspend the Running of Interest on Potential Underpayments

Present Law

Generally, interest on underpayments and overpayments continues to accrue during the 

period that a taxpayer and the IRS dispute a liability. The accrual of interest on an underpayment 

is suspended if the IRS fails to notify an individual taxpayer in a timely manner, but interest will 

begin to accrue once the taxpayer is properly notified. No similar suspension is available for 

other taxpayers.

A taxpayer that wants to limit its exposure to underpayment interest has a limited number 

of options. The taxpayer can continue to dispute the amount owed and risk paying a significant 

amount of interest. If the taxpayer continues to dispute the amount and ultimately loses, the 

taxpayer will be required to pay interest on the underpayment from the original due date of the 

return until the date of payment.

In order to avoid the accrual of underpayment interest, the taxpayer may choose to pay 

the disputed amount and immediately file a claim for refund. Payment of the disputed amount 

will prevent further interest from accruing if the taxpayer loses (since there is no longer any 

underpayment) and the taxpayer will earn interest on the resultant overpayment if the taxpayer 

wins. However, the taxpayer will generally lose access to the Tax Court if it follows this 

alternative. Amounts paid generally cannot be recovered by the taxpayer on demand, but must 

await final determination of the taxpayer’s liability. Even if an overpayment is ultimately 

determined, overpaid amounts may not be refunded if they are eligible to be offset against other 

liabilities of the taxpayer. 

The taxpayer may also make a deposit in the nature of a cash bond. The procedures for 

making a deposit in the nature of a cash bond are provided in Rev. Proc. 84-58. 

A deposit in the nature of a cash bond will stop the running of interest on an amount of 

underpayment equal to the deposit, but the deposit does not itself earn interest. A deposit in the 

nature of a cash bond is not a payment of tax and is not subject to a claim for credit or refund. A 

deposit in the nature of a cash bond may be made for all or part of the disputed liability and 

generally may be recovered by the taxpayer prior to a final determination. However, a deposit 

in the nature of a cash bond need not be refunded to the extent the Secretary determines that the 

assessment or collection of the tax determined would be in jeopardy, or that the deposit should 

be applied against another liability of the taxpayer in the same manner as an overpayment of tax. 

If the taxpayer recovers the deposit prior to final determination and a deficiency is later 

determined, the taxpayer will not receive credit for the period in which the funds were held as a 

deposit. The taxable year to which the deposit in the nature of a cash bond relates must be 

designated, but the taxpayer may request that the deposit be applied to a different year under 

certain circumstances. 

Description of Proposal

In general
105

The proposal allows a taxpayer to deposit cash with the IRS that the may subsequently be 

used to pay an underpayment of income, gift, estate, generation-skipping, or certain excise taxes. 

Interest will not be charged on the portion of the underpayment that is paid by the deposited 

amount for the period the amount is on deposit. Generally, deposited amounts that have not been 

used to pay a tax may be withdrawn at any time if the taxpayer so requests in writing. The 

withdrawn amounts will earn interest at the applicable Federal rate to the extent they are 

attributable to a disputable tax.

The Secretary may issue rules relating to the making, use, and return of the deposits.

Use of a deposit to offset underpayments of tax

Any amount on deposit may be used to pay an underpayment of tax that is ultimately 

assessed. If an underpayment is paid in this manner, the taxpayer will not be charged 

underpayment interest on the portion of the underpayment that is so paid for the period the funds 

were on deposit.

For example, assume a calendar year individual taxpayer deposits $20,000 on May 15, 

2005, with respect to a disputable item on its 2004 income tax return. On April 15, 2007, an 

examination of the taxpayer’s year 2004 income tax return is completed, and the taxpayer and 

the IRS agree that the taxable year 2004 taxes were underpaid by $25,000. The $20,000 on 

deposit is used to pay $20,000 of the underpayment, and the taxpayer also pays the remaining 

$5,000. In this case, the taxpayer will owe underpayment interest from April 15, 2005 (the 

original due date of the return) to the date of payment (April 15, 2007) only with respect to the 

$5,000 of the underpayment that is not paid by the deposit. The taxpayer will owe underpayment 

interest on the remaining $20,000 of the underpayment only from April 15, 2005, to May 15, 

2005, the date the $20,000 was deposited.

Withdrawal of amounts

A taxpayer may request the withdrawal of any amount of deposit at any time. The 

Secretary must comply with the withdrawal request unless the amount has already been used to 

pay tax or the Secretary properly determines that collection of tax is in jeopardy. Interest will be 

paid on deposited amounts that are withdrawn at a rate equal to the short-term applicable Federal 

rate for the period from the date of deposit to a date not more than 30 days preceding the date of 

the check paying the withdrawal. Interest is not payable to the extent the deposit was not 

attributable to a disputable tax.

For example, assume a calendar year individual taxpayer receives a 30-day letter showing 

a deficiency of $20,000 for taxable year 2004 and deposits $20,000 on May 15, 2006. On April 

15, 2007, an administrative appeal is completed, and the taxpayer and the IRS agree that the 

2004 taxes were underpaid by $15,000. $15,000 of the deposit is used to pay the underpayment. 

In this case, the taxpayer will owe underpayment interest from April 15, 2005 (the original due 

date of the return) to May 15, 2006, the date the $20,000 was deposited. Simultaneously with 

the use of the $15,000 to offset the underpayment, the taxpayer requests the return of the 

remaining amount of the deposit (after reduction for the underpayment interest owed by the 

taxpayer from April 15, 2005, to May 15, 2006). This amount must be returned to the taxpayer 
106

with interest determined at the short-term applicable Federal rate from the May 15, 2006, to a 

date not more than 30 days preceding the date of the check repaying the deposit to the taxpayer.

Limitation on amounts for which interest may be allowed

Interest on a deposit that is returned to a taxpayer shall be allowed for any period only to 

the extent attributable to a disputable item for that period. A disputable item is any item for 

which the taxpayer 1) has a reasonable basis for the treatment used on its return and 2) 

reasonably believes that the Secretary also has a reasonable basis for disallowing the taxpayer’s 

treatment of such item. 

All items included in a 30-day letter to a taxpayer are deemed disputable for this purpose. 

Thus, once a 30-day letter has been issued, the disputable amount cannot be less than the amount 

of the deficiency shown in the 30-day letter. A 30-day letter is the first letter of proposed 

deficiency that allows the taxpayer an opportunity for administrative review in the Internal 

Revenue Service Office of Appeals.

Deposits are not payments of tax

A deposit is not a payment of tax prior to the time the deposited amount is used to pay a 

tax. Thus, the interest received on withdrawn deposits will not be eligible for the proposed 

exclusion from income of an individual. Similarly, withdrawal of a deposit will not establish a 

period for which interest was allowable at the short-term applicable Federal rate for the purpose 

of establishing a net zero interest rate on a similar amount of underpayment for the same period.

Effective Date

The proposal applies to deposits made after the date of enactment. Amounts already on 

deposit as of the date of enactment are treated as deposited (for purposes of applying this 

provision) on the date the taxpayer identifies the amount as a deposit made pursuant to this 

provision.
107

S. Clarification of Rules For Payment of Estimated Tax for 

Certain Deemed Asset Sales

Present Law

In certain circumstances, taxpayers can make an election under section 338(h)(10) 

to treat a qualifying purchase of 80 percent of the stock of a target corporation by a 

corporation from a corporation that is a member of an affiliated group (or a qualifying 

purchase of 80 percent of the stock of an S corporation by a corporation from S 

corporation shareholders) as a sale of the assets of the target corporation, rather than as a 

stock sale. The election must be made jointly by the buyer and seller of the stock and is 

due by the 15th day of the ninth month beginning after the month in which the acquisition 

date occurs. An agreement for the purchase and sale of stock often may contain an 

agreement of the parties to make a section 338(h)(10) election. 

Section 338(a) also permits a unilateral election by a buyer corporation to treat a 

qualified stock purchase of a corporation as a deemed asset acquisition, whether or not 

the seller of the stock is a corporation (or an S corporation is the target). In such a case, 

the seller or sellers recognize gain or loss on the stock sale (including any estimated taxes 

with respect to the stock sale), and the target corporation recognizes gain or loss on the 

deemed asset sale. 

Section 338(h)(13) provides that, for purposes of section 6655 (relating to 

additions to tax for failure by a corporation to pay estimated income tax), tax attributable 

to a deemed asset sale under section 338(a)(1) shall not be taken into account. Some 

taxpayers may be taking the position that this exception applies to a section 338(h)(10) 

election and that when such an election is made, neither any stock sale nor any asset sale 

needs to be taken into account for estimated tax purposes. 

Description of Proposal

The proposal would clarify section 338(h)(13) to provide that the exception for 

estimated tax purposes with respect to tax attributable to a deemed asset sale does not 

apply with respect to a qualified stock purchase for which an election is made under 

section 338(h)(10).

Under the proposal, if a transaction eligible for the election under section 

338(h)(10) occurs, estimated tax would be determined based on the stock sale unless and 

until there is an agreement of the parties to make a section 338(h)(10) election.

If at the time of the sale there is an agreement of the parties to make a section 

338(h)(10) election, then estimated tax would be computed based on an asset sale. If the 

agreement to make a section 338(h)(10) election is concluded after the stock sale, such 

that the original computation was based on a stock sale, estimated tax would be 

recomputed based on the asset sale election. 

No inference is intended as to present law.
108

Effective Date

The proposal would be effective for transactions that occur after the date of 

enactment of the proposal. 
109

T. Limit Deduction for Charitable Contributions of Patents and Similar Property

Present Law

In general, a deduction is permitted for charitable contributions, subject to certain 

limitations that depend on the type of taxpayer, the property contributed, and the donee 

organization.211 The amount of deduction generally equals the fair market value of the 

contributed cash or property on the date of the contribution. 

For certain contributions of property, the taxpayer is required to reduce the deduction 

amount by any gain, generally resulting in a deduction equal to the taxpayer’s basis. This rule 

applies to contributions of: (1) property that, at the time of contribution, would have resulted in 

short-term capital gain if the property was sold by the taxpayer on the contribution date; (2) 

tangible personal property that is used by the donee in a manner unrelated to the donee’s exempt 

(or governmental) purpose; and (3) property to or for the use of a private foundation (other than a 

foundation defined in section 170(b)(1)(E)). 

Charitable contributions of capital gain property generally are deductible at fair market 

value. Capital gain property means any capital asset or property used in the taxpayer’s trade or 

business the sale of which at its fair market value, at the time of contribution, would have 

resulted in gain that would have been long-term capital gain. Contributions of capital gain 

property are subject to different percentage limitations than other contributions of property.

Description of Proposal

The proposal provides that the amount of the deduction for charitable contributions of 

patents or similar property (for example, patent applications, copyrights, trade names, trade 

secrets, trademarks) is limited to the lesser of the taxpayer’s basis in the contributed property or 

the fair market value of the contributed property (determined at the time of the contribution). 

The proposal applies to direct transfers of a patent or similar property to a qualified charity and 

to indirect transfers or other arrangements that are intended to disguise the contribution of a 

patent as a contribution of other property or otherwise to circumvent the rule of the proposal. 

Effective Date

The proposal would be effective for contributions of patents and similar property made 

after May 7, 2003.

 

211 Charitable deductions are provided for income, estate, and gift tax purposes. Secs. 

170, 2055, and 2522, respectively. 
110

U. Temporary State Fiscal Relief Fund

Description of Proposal

The proposal establishes a fund to provide $20 billion, equally divided among State and 

local governments, to be used for education or job training; health care services, including 

Medicaid; transportation or other infrastructure; law enforcement or public safety; and other 

essential government services.
111

V. Extension of Customs User Fees

Present Law

The Border and Transportation Security Directorate of the Department of Homeland 

Security collect nine different conveyance and passenger user fees and a merchandise processing 

fee. All of these fees expire after September 30, 2003.

Description of Proposal

The proposal extends the conveyance and passenger user fees and merchandise 

processing fee through December 31, 2013.

Effective Date

The proposal is effective on the date of enactment.
112

W. SSI Redetermination

Description of Proposal

This offset would align the initial review requirements for Title XVI with those currently 

required under Title II. As under Title II, the Commissioner of Social Security would be 

required to review initial Title XVI SSI blindness and disability determinations made by 

agencies in advance of awarding payments.

For FY 2004, the SSI review would be required for 25 percent of all State-determined 

allowances. In FY 2005 and thereafter, review would be required for at least 50 percent of statedetermined allowances. To the extent feasible, this offset would require that the Commissioner 

select for review the determinations most likely to be incorrect.
113

X. Covering Childless Adults with SCHIP Funds

Present Law

In 1997, when the State Children Health Insurance Program (“SCHIP”) was created, 

Congress specified that SCHIP allocations only could be used, “to enable [States] to initiate and 

expand the provision of child health assistance to uninsured, low-income children in an effective 

and efficient manner.” The use of funds dedicated by Congress to low-income uninsured 

children on childless adults is an inappropriate implementation of the SCHIP statute.

Description of Proposal

In the past, the Secretary of Health and Human Services has approved waivers that spend 

SCHIP dollars to cover childless adults. The proposal clarifies the intent of Congress; 

specifically stating that SCHIP funds cannot be spent on childless adults. It will no longer be 

legal for the Secretary to approve a waiver providing health insurance coverage through SCHIP 

to childless adults.